Credit scoring is quickly becoming one of the most-discussed topics in the mortgage industry and lately it has come under attack by consumer groups and some members of Congress.
Some of the strongest attacks on credit scoring focus on consumers? Seeming inability to change the credit score so as to change a denial into an approval quickly enough to rescue a deal or to keep from having to pay a higher interest rate, since some mortgage loans are now priced according to the borrower’s credit score. Since the score is based on information – positive and negative – in a consumer’s credit report, incorrect information – especially if that information is derogatory as defined by the model – can lead to a lower-than- warranted score. But, with the system now in place, correcting and deleting negative and incorrect information can take weeks, and even after the information is corrected by the creditor in its own files, the creditor often takes weeks more to report, via magnetic tape, the new, more-positive information to the credit repository (of which there are three: Trans Union, Experian – formerly TRW – and Equifax, which dominates here in North Carolina). But congressional, regulatory, and consumer pressure are coming to bear on this cumbersome, paper-based “corrections” system. Recently a credit industry official told me the credit bureaus – which are local that sell reports compiled by the three large repositories and which have the most direct contact with consumers – are negotiating with the repositories to be able to help consumers make changes faster. Under the proposal, the local bureau would check out consumer complaints directly with the creditor and, if the creditor confirms that the information is, indeed, incorrect, the bureau will be able to change the so-called “raw” credit file directly with all three of the repositories without waiting for the creditor to check out the complaint, update its files, and then send the updated information to the repository. A process that, as I noted, can take weeks – long enough to kill a deal.
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This is a major development. With the raw file changed, a new, possibly higher, score can be quickly generated, a deal rescued, and consumer and congressional concerns can be addressed.
Additionally, the three repositories continue to attempt to cooperate with one another, in theory sharing any updated, corrected information about consumers to insure their files are as accurate as possible. (But, just to be safe, consumers should make corrections with all three repositories directly – don’t assume anything; they are, after all, competitors.) The three repositories each use a different version of the Fair, Isaacs scoring model, but the model has been adjusted and weighted, so, theoretically, if all three had the very same information on you, your three scores would be identical. (A score of 640 at one repository would represent the same odds as a 640 at either of the other repositories, according the Fair Isaacs.) Of course, not all creditors report to all three repositories, so, even with adjustments, consumers can sometimes end up with three quite-different scores. While it is true that, in theory, you can have great credit with one repository and bad credit with another, I have rarely, if ever, seen that happen, although I have seen some pretty wildly varying scores. In a few cases I have seen borrowers with scores that vary by 100 points or more. To combat this variance, the mortgage industry usually uses the middle score, but that can be of little comfort to a borrower if he/she has scores of 550, 570 and 700, and the interest rate for a borrower with a 570 score is two points higher than for a borrower who has a 700 score. Still, keep in mind that this situation is rare. A borrower with good credit would, for example, have scores something like 685, 702, and 710.
Other new developments include outreach efforts to educate consumers about credit scoring by conducting seminars and sending out publications on the subject, plus efforts to make scores more readily available to consumers. Federal law says consumers do not have a right to see their score, but does not specifically prohibit lenders and creditors from revealing it (the credit report you can purchase from your local credit bureau does not have your scores posted – for now, only reports ordered by creditors have scores). Many in the mortgage industry, who know just enough about credit scoring to be dangerous, wrongly believe they are not allowed to tell you your score. That may be their company’s policy, but the Federal Trade Commission has made it crystal clear that it is illegal to reveal scores to a consumer, and some industry and consumer groups are now coming out in support of release of the scores. I strongly support the release of scores to consumers, so long as the scores are accompanied by information about how the scores are computed (my columns work nicely, I would think), so a number isn’t just shoved at a consumer with no context or explanation.
In fact, until recently, Fair, Isaacs has opposed the release of the score to the consumer, fearing that, as the company told me in an e-mail, since “the nature of credit risk scoring requires that consumers behave normally (and therefore predictable) when managing their credit and if large numbers of consumers receive and misunderstand their credit risk scores, their short-term behavioral changes could harm the predictive accuracy of the scoring model.” Fair, Isaacs position is that “the expansion of the credit industry in the 80s and 90s (was) made possible by expanded use of tools like credit scoring,” so anything that hurts the “predictive accuracy” of the model could make credit less-available. I would acknowledge that some might say that making credit less available is a good thing!
So, you might be wondering, just how is a score generated? A California-based company called Fair, Isaac http://www.fairisaac.com has created a complex, proprietary mathematical algorithm. By “back-scoring” millions of credit files using thirty-three or more “variables” that are grouped into five categories, from which your credit score is computed, and then analyzing the performance of those files, the company found the resulting score to be an incredibly accurate predictor of future rates of default or late payments. Of those scoring below 600, 1 in 8 would have one or more 90-day late payments. Above 700 that number slipped to just 1 in 123 and above 800 only 1 borrower out of 1,292 would have one or more 90 day late payments.
The five categories found to be more predictive (with their relative weighting in parentheses) are:
• Past Payment Performance (35%): Do you pay your bills on time? The more recent the late payments, the lower you credit score. In fact, a 30 day late payment today hurts more than a bankruptcy five years ago.
• Credit Utilization (30%): Have you maxed out your credit lines? Low balances on a few cards are better than high balances on one or two cards. Keeping balances below 30% of the credit line increases your chance for a higher score.
• Credit History (15%): The longer your accounts have been open, the better, so surfing for a new lower rate on a credit card and transferring balances can hurt your score.
• Types of Credit In Use (10%): Getting a loan at a finance company rather than a bank or credit union lowers your score.
• Inquiries (10%): Applying for new credit lowers your score, but multiple inquiries from the same type of creditor – like mortgage companies or car dealers – within 14 days count as only one inquiry. Promotional or administrative inquiries do not count against the score – only those times that you applied for credit count.
It’s no secret that Fair, Isaacs isn’t happy about the relative weightings leaking out, and it contends that the relative ratings above are not necessarily correct. The company, in an e-mail, to me “…the numbers change over time. That’s why we periodically update our models and scorecards to account for changes in consumer behaviors, lender policies, etc.” Well, then, now that we know how a score is computed, how do you go about improving it? Certainly the best way is to pay your bills on time. You should also keep your balances to below 30% of your credit line, and its better to keep some small balances on several cards rather than high balances on one or two. Maintain your accounts for a long period of time. Limit the number of times you apply for credit.
What if you have done all that and there is incorrect derogatory information on your report? Challenge it quickly with the help of a mortgage professional, and insist the creditor correct the information promptly. It can’t hurt to check out your credit report with a mortgage professional a few months before you intend to apply for a mortgage. But, in any case, with the increasing amount of identity theft occurring, you should check your credit report at least once a year anyway.