Are Credit Scores Obsolete?
“Credit is a system whereby a person who can’t pay gets another person who can’t pay to guarantee that he can pay.” - Charles Dickens
In this current economy where foreclosures, unemployment, bankruptcies and consumer credit defaults are reaching epic levels, are credit scores irrelevant?
A credit score is a numerical expression based on a statistical analysis of a person’s credit files, to represent the creditworthiness of that person. A credit score is primarily based on credit report information, typically sourced from credit bureaus.
Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system.
Credit scoring is not limited to banks. Other organizations, such as mobile phone companies, insurance companies, employers, landlords, and government departments employ the same techniques. Credit scoring also has a lot of overlap with data mining, which uses many similar techniques. – Wikipedia
With on-time payments being the greatest influence on credit scores, and more and more people unable to make on-time payments, credit scores will drop dramatically.
What happens when these same people are able to improve their financial situation? If they had some major credit issues, such as a foreclosure, then it could take years for their scores to increase to acceptable lending standards. Does that really mean that they are not a credit worthy borrower?
For example, let’s look at a hypothetical scenario. Three years ago, a mortgage loan officer purchased a $500,000 home on a stated-income, option arm. His credit score at the time was over 700. No-brainer. Three years ago, this deal would have flown through, no questions asked. Today, he is unemployed, can’t make the re-set payment, is underwater, and loses the house to foreclosure. He gets a new job in a different industry. He makes less money than he used to (a LOT less) but it is stable and pays his rent on time for a year. He’s clearly back on track and in a much better financial position. He’s probably learned some valuable lessons too, not just about his own personal finances, but about mortgage lending in general. Unfortunately, his credit score may still be well below the lender’s minimum when he goes to apply for a mortgage loan to purchase a home that he actually can afford.
In this scenario, this borrower is actually a much better credit risk than he was when he purchased the $500,000 home, but under today’s lending guidelines, he would be turned down. In reality, it was the first loan, on the $500,000 home that should never have been approved.
Lenders are still relying heavily on credit scores and automated underwriting systems in which credit score is a major determining factor. If the AUS approves the loan, the lender approves it, in most cases. This is even if the underwriter has concerns about the loan. Conversely, even if the loan does make sense, without an AUS approval, it will be declined. Lenders are still overriding underwriter’s decisions in favor of the AUS decision.
Have we learned nothing from the downfall of our industry (and subseqently the entire economy)? Isn’t it time to get back to basics, stop relying on statistics, scores and automated decsions? Shouldn’t an actual person with years of lending experience look at all aspects of an actual borrower and make a prudent decision based on the borrower’s overall current financial situation?
- Also published HERE.
Your example is great; however, your implied solution is impractical. We don’t all live in small towns where we are known personally. Mortgages, along with other pieces of life, are run through automated systems, because that’s what works with greater numbers of people. I think we’ll see lower scores being accepted by such systems once our economic turnaround begins.
My husband has been in the mortgage business for over 20 years and currently owns a broker firm with a partner. Even people with fantastic credit, scores, income, LTV etc are subject to crushing conditions, costing everyone time and money.
I very much agree with your comments. My family owns a mortgage company, I am a licensed mortgage broker and real estate agent with 6 years in the business, my father is also dually licensed with over 30 years experience. Our job as “professionals” is to guide our clients along the correct path. It is our job to know the in’s and out’s of the loan programs available how to realistically qualify a borrower.
Success in this business is based on relationships and understanding the need of the client. So I don’t think anyone can claim the AUS systems are the answer to underwriting. I have lost business over the years, especially during the boom, because I knew when a deal did not make sense for the borrower and I was not afraid to turn down a loan. I was often told that XYZ company down the street would do the loan – my reply “I have a conscience”.
I could have easily processed many loans through the automated systems and made three times as much money. However, today, my bank account is plentiful and I can sleep at night.
It is time to go back to the basics of personal relationships, educationing mortgage professionals on how to read a loan application, use a calculator, calculate debt to income ratios, and stop relying on computers to tell them what makes sense. Common sense is what we need again! Remember, AUS systems do not take in to account non-credit related expenses of the borrower. Most borrowers have plenty of financial obligations which do not appear on a credit report.
I have no doubt our government and lending institutions will not learn a lesson from the housing demise. Lisa is correct, the decrease in credit scores and increase in foreclosures and short sales will force lenders down the road to create “fancy” new loan programs to suit these borrowers. The cycle when begin again.
I do not however give all the blame to the lenders or wall street. So many investors and homeowners are taking advantage of the current situation. Otherwise creditable borrowers are walking away from properties or negotiating modifications simply because the equity has disappeared and there is no accountability required anymore.
We have become a society of “users”.
It’s time once again for face to face meetings with borrowers (something we have always required) and time for mortgage professionals to actually have training (and brains!).
Thank you for letting me interject!
I hope the current financial mess wreaks such havoc on the credit rating bureaus that they implode and credit scores become obsolete. There are too many mistakes in the system to make the information reliable enough to base life-changing financial decisions on. And screw this, “Check your credit report on a rotating basis every 4 months to make sure it’s accurate.” Why should WE bear the burden of correcting credit bureau incompetence?
I was just reading that credit card companies may start setting terms based on how their cards are used. For example, someone who regularly charges at a liquor store might get a higher interest rate.
You know that logic is going to trickle into credit ratings eventually, lowering scores for people who may charge porn, cigarettes, or anything else these “gateways to credit” decide is suspicious.
We’re shoveling money into banks and not even asking what they’re going to do with it. So why should an individual have to give a bank his financial life history?
Oh, I definately agree that using AUS only isn’t the way to go. I’m just pointing out that not using it doesn’t make sense, either. And also true is that many’professionals in the real estate business – agents, lenders, apprasiers, etc – are only out for a buck and not their client’s interest.
People need to start using their BRAINS again–and that means borrowers, lenders, and regulators.
I’m not suggesting that underwriters get to know their borrowers personally. You’re right, that would be impractical. Sure, the AUS helps, but an actual underwriter looks at the files anyway. The way it is now, and has been in the past, is the underwriter has very little say in the decision. My implied solution is that the underwriter make the decision, using the AUS and credit score only as guides.
Very well said. Thank you so much for your well-thought out comments. It is refreshing to hear from someone in the business who actually considers the borrower, not just what the investor will buy or how much they can make on the deal, regardless of weather or not it’s in the borrower’s best interests. We need more like you to get this business back on track.
Don’t even get me started on TARP, I think I could write an entire blog about that fiasco. Yes, lets hand the CEOs who have proven that they are inept at managing their companies billions of tax-payer dollars and not ask what they are going to do with it. I’m sure they won’t spend in on junkets to Vegas (Wells Fargo). Not only should they not have been given the money, they should be in jail or at least shouldn’t have their jobs.