FICO Scores and Mortgage Underwriting and Pricing

02.03.10

A recent short account in the New York Times told of a mother helping her son prepare his applications for medical school. She was bemoaning the fact that the admissions seemed to revolve almost completely around her son’s score on the MCAT, the Medical College Achievement Test. There seemed to be no one who would look at her son as a human being and assess his various personality and character attributes.

Someone made the comment that when you emphasize scores, you end up with doctors who are good at taking multiple-choice tests. Speaking as a patient, I want a doctor with a different skill set. Also mentioned in this account was a study done by researchers in Europe who gave personality tests to many hundreds of entering medical students and followed them through school. It turns out that some of the variables they tested, particularly the ability to concentrate, were far better measures of the student’s ultimate success than scores on standardized tests.

Mortgage underwriting has gone through a similar transformation. In the olden days, a human underwriter would look at a credit report and if there were derogatory items, the borrower would have also submitted a letter of explanation. The underwriter could evaluate the letter to help ascertain if the borrower was a flake or not. 

The human underwriter has been replaced by a computer, and software programs called Automated Underwriting were developed and implemented by Fannie Mae and Freddie Mac. It is important to note that neither Fannie nor Freddie uses the FICO credit scoring models developed by Fair Isaac Corporation scores in underwriting loans. They have developed their own proprietary credit evaluation schemes that are likely more accurate in predicting mortgage performance than a model that might have other primary functions. If your application gets approved, they believe that you will not default on your loan.

But they also realize that some borrowers are riskier than others, so in addition to the approval, they have developed their own “risk-based pricing models” so that borrowers with riskier characteristics pay more for their mortgage. Specifically, there are three elements to this. The first is the type of loan. Cash-out refinances are riskier than purchases or rate-and-term refinances because you don’t know what the borrower’s real intention is.

The second factor is loan-to-value. The less equity you put in, the higher the risk you pose to the lender. The third factor is creditworthiness, where borrowers with poorer credit histories will pay more for the loan. To see how these factors work and how pricing varies with changing characteristics, see the Fannie Mae matrix. 

Here is the strange thing. Instead of using their own proprietary mortgage-based risk evaluation model in evaluating creditworthiness, Fannie and Freddie chose to use FICO scores. And now we get back to the mother and her aspiring medical student son. Your loan might be approved by the Automated Underwriting system, but there are a lot of different programs that have their own internal rules. If your score doesn’t meet the minimum requirement, you can’t get a loan. An investor with many properties will have to have a minimum score of 720. 719? Sorry; better luck next time. Another rule says that a refinance using a Jumbo Conforming to pay off both a 1st and 2nd mortgage is a cash-out transaction and requires a 740 FICO score. 739? Sorry.

In addition, the risk-based pricing model has severe pricing penalties for FICO scores lower than 720. Note that the adjustments are cumulative. If your score is 675 and you want to do a cash-out refinance at 75 percent loan-to-value, you will pay a 2-point hit (Table 2 in the matrix) just for the loan plus a .75-point hit for the cash-out feature (Table 3 in the matrix), a total of 2.75 points. If you were planning on paying a 1-point loan origination fee on your $250,000 loan, you will now have to pay a total of 3.75 points, or $9,375. That might well be a deal-killer.

Here’s what is worse and why you as a consumer must be particularly vigilant:

It does not take much to drop your FICO scores. For example, a wealthy borrower I recently worked with had a mistake on his credit reports that almost cost him a loan. The problem was a $64 collection account. There was an accounting problem but it was sent to a collection agency just before it was straightened out.

We got the information together and the cable company told the collection agency to delete the derogatory reference. BINGO. His score went up from 692 to 773 – an increase of 81 points – and he got his loan. I can give you another dozen examples. You will note that all of the borrower’s other characteristics (wealth, income, quality of employment, etc.) were all ignored. This judgment was based solely on his FICO score. So will yours when you apply. For more information on the effects of various events on your score, check out this article.

I do not believe that there is absolutely any evidence to suggest, much less prove conclusively, that sporadic events of a minor nature like this are indicative of a character defect or increased likelihood of future deleterious credit performance. Therefore, they should not have any impact on a borrower’s score. In fact, in 2008 FICO announced the development of a new scoring system called FICO 08 that I understand ignores small derogatory events like this. But Fannie Mae and Freddie Mac have not adopted FICO 08. 

I hope you better understand the importance of checking your score regularly. Keep a clean credit history and make sure that you attempt to eliminate any derogatory reference, however insignificant you might think it is, if it is inaccurate. You might have thought that because it was so small that it doesn’t make any difference, but it does. I hope this article has disabused you of that idea.