Monday, April 07, 2008

Stripped Bare - Beneath the Feel Good Veneer of Subprime Lending

Chapter 10 - What’s the Score?

In addition to credit grades, which were discussed in the previous chapter, credit scores were also considered in subprime lending, though subprime borrowers’ credit scores were not as heavily weighted as the credit grade when subprime lenders set loan-to-value limitations.

What, exactly, is a credit score?  A credit score is a computerized, statistical method of reviewing an individual’s credit usage.  The computerized review of an individual’s credit trade lines generates a credit score for each individual credit user, and the most commonly recognized credit score is known as the “FICO” score.

Both prime and subprime lenders consider credit scores to assist them in making either a yes I will lend to this person, or no I will not lend to this person, decision.  Credit scores can range between three hundred (300) and nine hundred (900), though the lowest credit score I personally ever noted was 417.

Needless to say, the higher your credit score, the more apt you are to be approved for a loan, and the more attractive interest rate you will receive from the lender.  If your credit score is below five hundred (500) though, don’t bother contacting any subprime lender, because with a credit score below 500 you will not qualify for a mortgage.

The credit scoring technology utilized today is attributable to Fair Issac and Company; this is where the term “FICO” arose from; and the majority of mortgage lending institutions, including banks and other financial entities such as insurance companies, utilize the software and scoring methods developed by Fair Issac and Company to determine individual credit scores, and utilize this score as part of their decision making process.

There are three major credit reporting companies in the United States which generate credit scores.  One is Experian, which utilizes the Experian/Fair Issac credit scoring system, there is also TransUnion, which uses the Empirica credit scoring system, and the third major credit reporting company is Equifax, which uses the Beacon credit scoring system to calculate individuals’ credit scores.  All three of these companies consulted with Fair Issac and Company to develop the scoring methods used to calculate credit scores, though each company has added their own proprietary fine tunings to the scoring methods initially developed by Fair Issac and Company.

Though it is not difficult to find out what your individual credit score is today, only in the past ten years did this become possible.  As for the actual statistical methodology utilized by the big three credit reporting agencies to determine individual credit scores, this information is a tightly guarded, black box secret, though some of the basics for determining credit scores are as follows.

So what exactly does the secretive credit scoring computer look at to determine your score?  A large percentage of the your score, thirty-five percent (35%), is based on your payment histories with your current creditors.  Another large percentage of your score, thirty percent (30%), is based on how much actual debt you have outstanding.  For example, how many car loans do you have, credit card balances, student loans, etcetera.  In addition to these items, the scoring system also considers if you have maxed out your credit limits.

Fifteen percent (15%) of your score is based on how long you have actually been a credit user.  For example, did you first start using credit ten years ago, fifteen years ago, or have you only recently become a credit user in the past year or two?

Another ten percent (10%) of your credit score is based on the number of inquiries on your credit report.  An inquiry is simply a bank, car dealer, insurance agent, credit card company, or other financial institution’s request to review your credit use.  Too many of these credit inquiries will lower your score, and many subprime borrowers’ credit reports showed twenty (20) or more recent credit inquiries.

The final ten percent (10%) of your credit score is based on the types of credit you have outstanding.  Are your creditors unsecured creditors, like credit cards, or are your creditors secured creditors, like boat and automobile loans, or home mortgages?  The mix and match of these different types of credit will affect your credit score.

All of the above listed factors are then crunched through the credit bureaus’ credit scoring systems, and your individual credit score is then spit out for lenders to ponder over whether you are a sound credit risk, or someone they should send down the road with your hat in your hand because you are an unsound borrowing risk.

Most mortgage lenders, whether prime or subprime, require what is called a tri-merge credit report when you apply for a home mortgage.  A tri-merge credit report compiles your individual credit data from all three major credit bureaus, and each credit bureau’s credit score for you as individual based on the factors noted above.  Because each individual credit bureau has fine tuned the initial credit scoring technology developed by Fair Issac and Company, and each credit bureau considers their fine tunings as proprietary, you will end up with three different credit scores showing on your tri-merge credit report.  Most subprime lenders threw out the high and the low credit scores, and utilized the mid-score as your credit score when determining individual borrowing risk.

For example, let’s say that a tri-merged credit report for you shows a high credit score of 700, a mid-score of 665, and a low score of 640.  Most subprime lenders would have utilized the mid-score of 665 when evaluating your individual potential credit risk.

As previously noted, when being evaluated for a subprime loan both your credit grade, and your credit score, were considered by the subprime lender.  If your credit score was high, which typically means you pay the majority of your creditors on time, but your credit grade was low, which means that you typically payed your mortgage payment over thirty days late, it would negatively affect the terms of the subprime loan being offered to you.

The adverse can also be true.  If your credit score is low, say between 620 and 590, which typically meant you were paying some of your creditors late, but your credit grade was high, which means you were making your mortgage payment on time, you would in all likelihood receive better lending terms than the borrower with a high credit score and a low credit grade.

Because all subprime loans were contingent upon your individual credit grade and credit score, and, because each subprime lender could set their own lending criteria, subprime borrowers may have found different subprime lenders offering different lending terms for the same mortgage.  This was not unusual.  But bear in mind, the different lending terms offered to subprime borrowers, by different subprime lenders, may have only been different because one subprime lender may have been looking to profit more from a subprime borrower than the other.

Subprime borrowers’ credit scores could be re-calculated rather easily, and it was fairly standard practice for subprime lenders to request a credit score re-calculation for borrowers considering a subprime loan.  In many cases, it was not unusual for a borrower’s trade line, which was currently being reported on their credit report as being delinquent, or as charge-off or collection, to be incorrect.  In instances where this occurred, if the borrower submitted documentation which proved that an account was in fact current, or that a collection or charge-off had been satisfied, the documentation would be submitted to the three main credit bureaus and an updated credit report would then be requested based on the supplied information.  In many instances where this occurred, the updated credit report would reflect a higher credit score, which could increase borrowers’ loan-to-value limitation by five percent (5%), and this 5% increase in the mortgage amount could in turn make a deal out of what previously had been a dead horse.

Posted by John Venlet on 04/07 at 06:10 AM
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