How Does FICO Determine Borrower Risk?

Banks have risen their thresholds for what is considered average, good, and great credit, so many approvals have begun to fall through the cracks or consumers have wound up paying much higher premiums for loan approval. When borrowers learn they may pay over $100,000 to $500,000 more, and possibly more in the case of jumbo loans, for a loan due to lower credit scores they realize how important knowledge of credit and the value of great scores can be.

If an applicant is borrowing $700,000 through a Fannie Mae loan and they have a 660 to 739 FICO score they may have to come up with $19,250 in points at closing (a point is 1% of the loan) or pay a 5% interest rate over the loan term. On the other hand, if the buyer had a 740+ FICO credit score they would not have to pay any points and the rate could be 4%.

Let’s say they don’t have the additional $19,250 to buy the rate down that extra 1% what, would happen?

Buyer A has a 660 credit score and pays 5% interest on the $700,000 loan. Over 30 years the cost would be $1,352,796.

Buyer B has a 740 plus credit score and pays a 4% interest rate on the $700,000 loan. Over 30 years it will cost him $1,203,094.

THE SAVINGS WOULD BE $149,702!!

To have great credit scores we must understand the factors that the FICO formula uses to tabulate a score:

  1. Payment History:

    Payment history weighs heavily on FICO credit scores. Most collection accounts can stay on reports for 7 years and will have a significant impact during the first 2 to 4 years.

  2. Amount of debt:

    Your balance to limit ratio will have an impact on the overall health of your credit and on how responsible you are with revolving credit accounts. Keep your balance to limit below 7 – 10% of the limit to maintain the best scores. Lenders are now using Trending Credit Data to learn more and look back further (2 years) into the revolving payment and debt history of an applicant. Consider this if you plan on buying a home in the next few years!

  3. Length of credit history:

    You don’t have much control over the age of your accounts, but as you (and your accounts) get older, the better your credit scores will get. Build healthy credit by managing all accounts, paying bills on time, and keeping your balances low.

  4. New credit:

    A hard inquiry is created when you authorize a creditor or lender to pull your credit scores/reports. If done responsibly, inquires should only drop scores a few points. Whenever you open new credit expect to see an impact on your scores.

  5. Types of credit used:

    Make sure you’re using a variety of credit – revolving credit cards, store credit cards, installment loans, and maybe a mortgage will offer you a good mix of credit account types.

Revolving credit includes overdraft on checking accounts, lines of credit, credit cards, and some home equity lines. Since revolving credit is the type that consumers have the most control over, the balances have a greater affect on credit scores. The higher the balances inch up to the aggregate limit the more the scores drops. Also, the individual balance to limit ratios of each account can affect the score negatively. If there is no limit listed on the credit report, automatically, the highest balance becomes the limit.

Here is an example about the impact payment history can have on credit:

Lisa is getting ready to purchase a property in NYC and will need loan approval for over a million dollars. When asked by the realtor how her credit scores were she stated, “They should be great”. The realtor suggested Lisa meet with a banker to get a pre-approval letter so they can begin shopping for a property. Lisa meets with the banker and is shocked to find out that her FICO score was a 650. Lisa had a thirty day late payment last month with a credit card for $15.00. Although Lisa was on time with all her other accounts, because the late payment occurred so recently her credit score dropped 90 points. She was amazed to find out it is not the amount of the late payment that affects the credit but the timing of when it happens. While Lisa earns over $500,000 a year and has great savings and investments, it didn’t matter much to her score, as her credit is only showing the bank what her payment patterns are. The score cares little if the late payment was $15 or $50,000. Lisa cannot even get loan approval with this poor credit score.

Luckily for Lisa we were able to remove the late payment from her credit and she will be ready to get approved once she finds the right property. Lisa was fortunate to learn early on in the process that her score needed work and we were able to help her.

New negative credit is much more damaging to credit scores since it has to reflect to the score that this consumer is a much higher risk borrower. Since statistics show that the majority of consumers with new late payments and delinquencies wind up defaulting, the score has to reflect the new higher risk category to the lender. How it works is the higher your credit score the more it has to dip after a delinquency to reflect the risk change. For example, with an already poor Fico score at 590, a new late payment might drop the score an additional 10-15 points; whereas, an exceptional 780 Fico score would have to drop 100 points to bring the risk level up substantially. A 680 is the lower end of good. So it is very possible that a consumer with a bankruptcy 5 years ago can have a better score than one with new late payments.

Making sure credit is analyzed with future financial goals in mind is a MUST before taking an action that can foil those plans and limit a consumers options for a better quality financial life. Feel free to message me or visit our website www.northshoreadvisory.com for more information.

(Updated June 2017)