Loan Processing – Credit Reports
Alternative Financing and Telework Loan Programs
Annual Meeting
Washington, DC
December 13, 2004
By
Brett Christensen Executive Vice President Lending Solutions Consulting, Inc.
bchristensen@rexcuadvice.com
FICO Credit Scores
“How They Really Work”
Credit Score Enhancement
Well trained financial institution employees can teach borrowers how a FICO score is calculated and how a borrower can improve their score. By offering this service, the financial institution would have a unique competitive advantage over other lenders.
FICO Score Knowledge Quiz
1. What aspect of a borrower’s credit history is the most heavily weighted factor in computing the FICO score?
2. What aspect of a borrower’s credit report is the second most heavily weighted factor in computing the score?
3. Is a borrower’s income a component of the score?
4. Is length of residence a component of the score? 5. Is total debt ratio a component of the score?
6. Is length of employment a component of the score?
7. Does the score take into account when good or bad credit occurs?
8. What advice do you presently give borrowers that want to improve their score?
FICO Scores
FICO scores range from 300 to 850. The score predicts the likelihood of 90+ day delinquency over the next 24 months. The approximate percentages of borrowers that fall in to each credit category are:
A+ and A-paper (scores greater than 680): 65% B-paper (scores between 640 & 680): 15% C-paper (scores between 600 & 640): 5% D-paper (scores between 550 & 600): 12% E-paper (scores less than 550): 3%
A financial institution can vary a great deal from the above percentages. Financial institutions that serve high income, stable employer groups tend to see even more A-paper borrowers. Financial institutions that serve lower income borrowers, unstable employer groups and have community charters will most likely attract lower credit-quality borrowers. It is important for a financial institution to know its credit demographics because:
• More A borrowers = lower delinquency & loss and lower loan yields.
• More C, D, and E borrowers = higher delinquency & loss, but higher loan yields to pay for the losses.
Score Composition
Payment History 35%
Amount you Owe (Capacity) 30% Length of Credit History 15%
Types of Credit 10%
New Credit 10%
FICO Credit Scores
The purpose of a credit score is to show the user of the FICO score what the probability is that a borrower will or will not default based upon their current and past credit history. While not perfect, scoring models are a tremendous tool and can best be used in pricing risk-based loans & in helping the decision maker in granting loans – pointing out the risk & probability of default.
All told there are about 50 different characteristics that are weighed in the FICO scoring models. The credit bureaus will not tell us all of the characteristics and their assigned weights. However, Trans Union has shown us five of their characteristics on the following table and the weights assigned to each characteristics.
EMPIRICA SCORECARD
Characteristic: Attributes Points
# bankcard trade lines 0 12
1 22
2 30
3 40
4 45
5 or more 50
# finance trade lines 0 75
1 55 2 40 3 35 4+ 20 # months in file <12 12 12 - 23 35 24 - 47 60 48+ 65
# months since most recent No bankcard 32
bankcard opening bankcard, but no open date 32
0 - 5 20 6 - 11 25 12 - 17 30 18 - 23 38 24 - 35 45 36+ 50
# months since the most No public record 75
recent derogatory public 0-5 10
record 6 - 11 15
12 - 23 25
24 - 47 38
FICO Score Reason Codes
Score reason codes explain the top reasons why a FICO score is not higher. These score reason codes are more useful than the score itself in helping a person determine whether their credit report might contain errors and how they might improve their score over time.
However, if you already have a high score (for example, in the mid-700s or higher) some of the reasons may not be very helpful; as they may be marginal factors related to the categories that are weighted the least (length of credit history, new credit, and types of credit in use).
Here are the top 10 most frequently given score reasons: 1. Serious delinquency.
2. Serious delinquency, and public record, or collection filed.
3. Derogatory public record or collection filed. 4. Time since delinquency is too recent or unknown. 5. Level of delinquency on accounts.
6. Number of accounts with delinquency. 7. Amount owed on accounts.
8. Proportion of balances to credit limits on revolving accounts is too high.
9. Length of time accounts have been established. 10. Too many accounts with balances.
What a FICO Score Ignores
• Your race, color, religion, age, national origin, sex and marital status.
• Where you live, your salary, occupation, title, employer, date
employed or employment history.
• Any interest rate being charged on any loan on your credit report.
• Any items reported as child/family support obligations or rental
agreements.
• Whether or not you are participating in a credit counseling service of any kind.
• Certain types of inquiries. The score does not count
“consumer-initiated” inquiries – requests you have made for your credit report in order to check its validity. It also does not count “soft” inquiries such as promotional inquiries made by lenders in order to make you a pre-approved credit offer; or administrative inquiries made by lenders to review your account with them. Inquiries that are marked as coming from employers are also ignored.
“You may have heard that a large number of inquiries can have a negative impact on your credit score, but you are probably OK. The vast majority of inquiries are ignored by the FICO scoring models. They are not the steak in the steak dinner. For instance, the model has a buffer period that ignores inquiries within 30 days of getting a mortgage or a car loan. It also counts two or more “hard” inquiries for autos or mortgages in the same 14-day period as just one. You could have 30 inquiries in a two week period and it only counts as one.”
How Important is Capacity
of Credit Cards?
The FICO model knows that the majority of Americans who go bankrupt run up their credit cards to the limits before filing.
Let’s illustrate how a FICO score is affected by a borrower that decides to consolidate their credit cards and close out their accounts - and thereby hoping to improve their score:
Before After
Eight credit cards Two credit cards $40,000 in limits $10,000 in limits $10,000 in balances $10,000 in balances 75% available capacity 0% available capacity
In this example, the borrower is no further in debt, yet their credit score will drop dramatically because the lender removed all of their available capacity on their credit cards.
If a lender requires a borrower to close out their credit cards as a condition of a loan, they diminish their capacity and they lower their score! Therefore, only require a borrower to close out credit cards when it is absolutely necessary – or don’t do it at all. If you are closing out your own cards for non-use you are reducing your available capacity – and your own credit score.
The “Fragile A” Borrower
One of the weaknesses of the FICO scoring model is that often a borrower will earn a very good score (700+) with little or no credit to base the score upon. I refer to this as the “Fragile A.” Some of the characteristics of the “Fragile A” are:
• The borrowers are typically young. • They have very few trade lines.
• Their credit histories are very limited.
• The dollar amounts of credit they’ve had are
small.
A lender has to be very cautious of the “Fragile A” borrower because any type of hiccup in their credit can result in their score dropping from A to D overnight. This is because there is very little substance to their credit report. Some lenders automatically approve borrowers for certain loan products such as credit cards solely on the basis of their score being above a certain number.
The key thing for a lender to remember is that if they do approve them, they need to underwrite the borrower like they are C paper. They can either give the borrower an A-paper rate today or write a policy provision stating that limited credit (say less than two years) will get a C-paper rating. This is my recommendation. Don’t forget that in a year or two they will re-apply and the lender will then learn the borrower’s true colors. And don’t forget, a lender doesn’t have to approve them. This
discussion is also valid for the occasional “Fragile E” borrower that a lender will encounter.
FICO Score Conclusions
1.
It is very difficult to score above 700 with a
currently delinquent account.
2.
To score above 730, maintain a high level of
capacity on the revolving accounts and have no
current or past public records and delinquent
accounts.
3.
It almost always takes little or no capacity and
current delinquencies to score less than 500.
4.
Scores in the 600s usually can be described in one
of two ways:
•
Paying well (on time), but have only average
capacity, or
•
Paying OK (occasional sloppiness), but have
FICO SCORES
Understanding the Crossroads
that Lead to Explaining the Score
Approximate Credit Weight
for each Year
40% = current to 12 months
30% = 13-24 months
20% = 25-36 months
10% = 37+ months
What makes up the score?
35% = Payment History
30% = Capacity (Capacity is King)
15% = Length of Credit
10% = Search & Acquisition for
New Credit
10% = Type of Credit
What actions will hurt
the score?
Missing payments (regardless of
$ amounts…It will take 24mo to restore credit with one late pay).
Credit cards at capacity (i.e.
maxing out credit cards).
Closing credit cards out (this
lowers available capacity)
Opening up numerous trades in a
short time period.
Having more revolving loans in
relation to installment loans.
Loans at finance companies.
How to Improve the Score
Pay down on credit cards.
Do not close credit cards.
because capacity will decrease
Continue to make payments on
time (old late pays will become less significant with time).
Slow down getting new loans.
Acquire a solid credit history
with years of experience.
Move revolving debt to
installment debt.
What does not Affect the
Score
Debt ratios
Income
Length of residence
