Is the Credit Scoring Model for Home Loans Outdated?

Written by
David Mully
Read Time: 6 minutes

A federal decision on new rules to a credit scoring model that some mortgage lenders consider outdated has been put off for two years, potentially hurting home shoppers who don’t have a credit history and are “credit invisible” or only have a short credit history.

The Federal Housing Finance Agency has decided to put off until 2020 a decision to use other credit scoring models on home loans it backs through Fannie Mae and Freddie Mac. Those agencies currently use the traditional FICO credit score.

For more than a year the FHFA has been looking at switching to the latest version of FICO, called FICO 9, or to another credit score called VantageScore 3.0, or a combination of scores.

Credit scores are used to determine if a borrower is a good risk for a loan. The FICO score used by Fannie and Freddie — which own or guarantee mortgages — requires loan applicants to have a credit account open for at least six months as a way to assess credit risk properly.

Without it, they’re among the 26 million consumers in the United States who are credit invisible, representing 11 percent of the adult population, according to the Consumer Financial Protection Bureau, or CFPB. Another 19 million people, or 8 percent of adults, had credit records that were treated as unscorable, also called having “stale credit” because their credit history doesn’t have enough recent activity to give an accurate picture of creditworthiness.

Both groups could be shut out of federally insured home loans, which is why the FHFA is looking into revamping the scoring system used by Fannie and Freddie.

The latest FICO version

Many people with stale or invisible credit have low incomes. Almost 30 percent of consumers in low-income neighborhoods are credit invisible and an additional 15 percent have unscored records, according to the CFPB.

While they may not qualify for Fannie or Freddie home loans, they can still be considered responsible with their money and pay their rent, utilities and phone bills on time. Those three bills aren’t considered in evaluating mortgage applications or on FICO scores, but are part of a new credit score, called Ultra FICO, that isn’t used by Fannie and Freddie but is being rolled out in 2019. Lenders working with Finicity, a company that builds financial apps, says its CEO, Steve Smith.

The new score can help people who don’t have credit cards or haven’t bought a car, such as millennials, Smith said, and thus have a thin credit file or are credit invisible.

It’s unclear if the FHFA will consider Ultra FICO, which was announced as a new type of credit score in October 2018.

It allows a consumer to grant permission to use information from banking statements. This includes how long accounts have been open, frequency of activity, and evidence of saving.

“It includes information on how you manage money through your bank account,” Smith says.

Experian, FICO and Finicity estimate the new score could improve credit access to people with credit scores in the upper 500s to low 600s, or who fall just under a lender’s score cut-off. People with a limited credit history or previous financial distress and who are getting back on their feet stand to benefit the most, the groups say.

One scoring model being considered by FHFA is the VantageScore model, which is owned by the three primary credit bureaus — Experian, Equifax, and TransUnion. It allows a credit score to be calculated without a full six months of credit data to analyze. That’s something FICO doesn’t have.

Proposed changes

The FHFA is considering four scenarios for how Fannie and Freddie would use scoring models:

  • One score: Either FICO 9 or VantageScore 3.0 would be required, or the current FICO score could remain.
  • Both: Both of the newest scores, if available, would be required on every loan. This would require policy decisions on how to treat borrowers with one credit score but not the other.
  • Lender choice: Lenders would choose one score or the other for a certain amount of time, such as a year. A policy decision would have to be made on if mortgage brokers would use one score or aggregate loans written with both scores.
  • Multiple scores: A primary and secondary credit score would be set by using multiple scores.

Outdated and unfair?

The point of changing the credit scoring model is to help people with little or no credit get mortgage loans that they may not get under the current rules. Lenders would still require evidence of being able to repay the loan, such as a low debt-to-income ratio.

If fewer people are using credit cards, that could lead to a thin credit file and fewer people qualifying for Fannie and Freddie-backed home loans. A survey by Bankrate found that just one of three millennials have credit cards. They’re more likely to use cash and use debit or prepaid cards.

Until the newer credit scoring models are studied more by the FHFA and a decision is reached on using them in federally-backed home loans, the older version of FICO will continue to dominate the mortgage credit market and may lock out some potential borrowers with little or no credit file.

The greatest worry among critics, however, is that adding a different credit score to the mix could lead to greater risk for lenders, and eventually to another housing crisis or Great Recession, when interest-only loans were popular. That’s a big leap to make, and one that the FHFA may consider in its decision to allow more credit scores to be considered by mortgage lenders.

Another fear is that if offered two scores, the highest score may not contain the best information a lender needs, says Savannah Martin of Two Minute Topics, a resource for consumers.

“Although using the highest credit score may help consumers get approved, they may not be qualified for the loan they are looking for,” Martin says. “Lenders have tried this in the past, which led to the 2008 recession. Giving a consumer’s highest credit score would mislead lenders to approving loans people are not qualified for.”

Other factors in the FICO model used by Fannie and Freddie are also outdated, and shouldn’t apply to a mortgage approval, says David Krichmar, a mortgage banker at Legend Lending Corp. in Texas.

They include using the amount of recent credit inquiries and maxing out credit cards, Krichmar says. Charging a lot on credit cards shouldn’t matter as much as making payments on time, he says.

And if someone is shopping for a car or mortgage and has a lot of recent credit inquiries, it isn’t a sign that they’re opening a lot of credit accounts, which is likely what the scoring model was designed to measure, he says.

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