Until 1993,
mortgage lenders had traditionally relied on underwriters to determine if
a borrower was worthy of a mortgage loan. The underwriter would mail out
employment and bank verifications, order a credit report and review each
piece of information when it was received. The underwriter or loan
committee would meet to determine if the borrower met the guidelines
established for the type of loan he was applying for. This process would
often take weeks or even months to gather the information and make an
underwriting decision. In today's fast paced market, lenders want to be
able to make decisions within 24 hours, if possible. So lenders have had
to change the way mortgage loans are underwritten.
One of the first changes made to speed up the underwriting process was to
accept verifications of employments through pay stubs, rather than written
verifications through the U.S. mail. Likewise, bank statements have
replace the need for written bank verifications. Court papers and canceled
checks are often used as proof of additional income sources such as child
support or alimony. Next, credit reports started coming with credit
scores.
Credit scoring is a numeric way of weighing various financial factors,
like income, debts, job history, credit history, and other factors, which
can help predict the likelihood of the borrower defaulting on the
mortgage. While there are a number of credit scoring models used, most
lenders seem to use the Fair, Isaac & Co. (FICO) score that ranges from
450 to 850. The lower the score the higher the risk. Credit scoring is no
part of the credit report that the lender gets when a borrower applies for
a mortgage, although the borrower isn't usually allowed to see his credit
score, unless the lender is willing to share the score with the borrower.
While the credit scores have some merit, there are different systems of
scoring and the borrower may actually have three different credit scores
at the three major credit bureaus. This is why FNMA recommends that
lenders obtain credit scores from two of the three major credit bureaus
and compare the scores. The lower score is used when only two scores are
obtained. The middle score is used if all three credit bureaus are used.
While the credit score is only a tool to help lenders determine their
risk, FNMA conducted tests on one million loans and found that one in
eight borrowers with a FICO score below 600 were either severely
delinquent or in default. On the other hand, borrowers who had a FICO
score of 800, only one in 1300 borrowers were severely delinquent or in
default.
Most lenders who sell their loans in the secondary mortgage market (almost
all do so) use the following guidelines on credit scores:
-- Scores 660 and above- credit risk is generally acceptable. A score
above 660 can help compensate for other risks in the credit file.
-- Scores between 620 and 659 calls for a comprehensive review to take a
closer look at potential risks. Supplemental credit documentation and
letters of explanation my be required.
-- Scores below 620 require cautious review. Borrowers in this category
may have to pay subprime interest rates such as A-, B, C, or D category
loans. Occasionally compensating factors such as additional down payments,
extra cash reserves or very low debt ratios may allow the underwriter to
approve the loan in the A category. Generally, compensating factors are
not sufficient to overcome poor credit scores.
Once the underwriter has obtained the proof of employment, proof of assets
and the credit report to include the credit scores and all other required
documents, he may seek loan approval through Automated Underwriting
Systems (AUS) which are available through FNMA and FHLMC. The computers
(using models) can approve a buyer for a mortgage loan and the purchase of
that loan in two minutes or less. This not only speeds the qualifying
process for the borrower, it also assures the mortgage lender that there
is a source to sell the mortgage to in the secondary mortgage market.
Today's mortgage transaction can actually go from loan application to loan
closing in 3-10 days with advanced underwriting systems now in place.
many borrowers want to know how credit scoring works and if they can
improve their credit scores. Credit scoring takes into account numerous
components. For example, the longer that you have had credit without late
payments the higher the score. The more sources of good credit references
that you have the higher the score. On the negative side, slow payments
lower the credit score, as do errors on a credit report that have not been
corrected. in addition, credit scoring also weighs how much available
credit the borrow has used. For example, if account balances are 75% or
more of the credit limit, it may signal high financial leverage and a
higher risk to the lender. Since the lender compares the amount of debt
the borrower carries compared to the amount of income he earns, it is
important to keep available credit reasonably low.
Maintaining a large number of accounts with zero balances is also
considered a negative in credit scoring, because it increases the
borrower's potential to live beyond his means. A borrower could actually
increase his credit score by closing some of their accounts with zero
balances. The borrower should notify the creditor in writing that he wants
to close the account and send the notice return receipt requested so the
request cannot be ignored. Ask the creditor to post "closed at customer's
request." Opening new accounts is considered a negative in credit scoring.
So a borrower who plans to apply for a mortgage loan should close some
accounts rarely used and not open any new accounts, if desiring the
highest maximum credit score. Moving a credit card balance to a lower
interest rate card may even lower the credit score, unless the borrower
specifically notifies the credit bureau of this change. (The lender is
powerless to change the credit score, they can only suggest ways that the
borrower can get them changed). The borrower needs adequate time to change
a credit score, as it takes time to get accounts closed and posted to the
credit report etc.
In general, a borrower is considered to have good credit and would be
eligible for "A" quality loans and interest rates as long as their credit
report shows nothing more detrimental than the following and could
adequately explain why any payments were past due:
-- Revolving credit (credit cards): No more than two payments 30 days past
due, and no payments 60 days past due.
--Installment credit (car loans): No more than one payment 30 days past
due and no payments 60 days or more past due.
--Housing Debt (first second mortgages or rent): No payments past due.
If the borrower's credit does not fit the above guidelines, they would not
be eligible for "prime" secondary mortgage market loans and interest
rates, however a "subprime" lender could still make them mortgage loans at
higher interest rates. Simply stated, a borrower who is not eligible for
the going rate can elect to pay A-, B, C, or D rates, designed to protect
the lender against the greater risk of default. Since no secondary
mortgage market exists for these loans, lenders can charge anywhere from
an additional one half percent interest for an A- buyer to four or five
percent higher interest rates for a D borrower who has had a recent
bankruptcy or foreclosure.
Caution: before you let your borrowers apply for a subprime mortgage rated
A-, B, C, or D, have them get a second opinion from another conventional
lender that makes A loans. Sometimes the borrower has inadvertently been
referred to a subprime lender that only offers B, C and D loans. Also have
them check out FHA and VA loan possibilities as these government insured
loans are often more lenient when it comes to credit problems.
Compensating factors such as increased down payments also can overcome
credit problems on FHA and VA loans that conventional lenders would
reject.
