The Role of the FICO® Score in the Mortgage Consumer Credit Risk Ecosystem
The FICO Score is a primary factor in determining consumer credit risk for mortgage originations, secondary market, and portfolio management with consumer and regulatory benefits
Applying for a mortgage is a significant event in many people’s lives, whether it’s a first-time homebuyer or a family purchasing their dream home. Yet, that is just one of the many steps throughout the mortgage lifecycle. Prior to application, lenders often work to evaluate prospective borrowers using the FICO Score through prequalification or preapproval processes. This helps streamline the loan process by determining early on whether the consumer is likely to qualify or be approved for a mortgage loan. Then, when a product offer is a good fit, the borrowers apply, but that is just the beginning of the mortgage origination process. The application then goes through underwriting, and if approved, the loan is originated. Afterwards, lenders either hold mortgages on their own books, or they sell them in the secondary market to free up capital for new loans. The secondary market plays a critical role in keeping mortgage funds flowing, and FICO® Scores are the lifeblood to this process.
FICO® Scores help standardize credit risk evaluation across lenders, geographies, and time. Investors like Fannie Mae and Freddie Mac bundle mortgages they purchase into mortgage-backed securities that they sell to secondary market investors, and the value of these securities depends on the quality of the underlying loans. Key indicators, such as loan-to-value ratios and debt-to-income ratios, are important, but the FICO Score is a primary factor in determining a loan’s credit risk profile and cash flows. Higher FICO Scores generally signal lower credit risk and more stable cash flows, while lower credit scores often indicate a higher risk of loan default though they may also signal a lower likelihood to refinance. The FICO Score at origination is often the same score used by investors and others downstream throughout the 30-year lifecycle of the loan. It is often used year after year to value, sell and repurchase the loan and its servicing rights.
When valuing mortgage-backed securities, investors are primarily concerned with cash flow predictability. Two key factors that impact cash flow are charge-offs, which occur when a borrower defaults, and prepayments, which occur when a borrower pays off the loan early. Both scenarios stop providing cash flow to the investor. FICO® Scores help predict the likelihood of these events—loans with higher FICO Scores are less likely to default, while lower credit scores can reduce the risk of prepayment but increase the risk of default.
The FICO® Score is critical to many stakeholders across the mortgage ecosystem, serving a wide range of essential functions.
In the mortgage sales and pre-origination phase, lenders use FICO® Scores for:
Prequalification: Soft pull of a FICO Score is often used to evaluate a borrower’s likelihood for qualification of a loan early in the process. This not only helps streamline the process, but it enables lenders to more effectively compete in the marketplace and to more efficiently expand the availability of mortgages by identifying more potential qualified borrowers in an efficient and cost-effective manner. It also drives efficiency by identifying unqualified borrowers upfront, benefiting both lenders and consumers by avoiding the time and cost of unnecessary applications.
Preapproval: A FICO Score, typically as a hard pull, is used by lenders early in the process as a solid basis to quickly assess a prospective borrower for loan preapproval, giving them confidence to shop for the right home from the beginning.
Product Decisioning: Borrowers are aligned with appropriate loan products based on their FICO® Scores; to help ensure they are matched with loans that are the best fit in increasing the likelihood of home ownership. Loan officers use the score to help guide potential borrowers to the best available product options, simplifying the process for the consumer and reducing potential mismatches.
Product Guideline Creation: Lenders typically define product guidelines based on credit. As a universal credit standard, FICO® Scores provide a reliable and consistent, common measure of consumer credit risk, enabling the creation of new loan product offers for consumers.
Sales Campaigns: FICO® Scores enable lenders to market more strategically, targeting brokers and potential borrowers through broker relationships and direct mail campaigns, optimizing their outreach to those more likely to qualify for loans.
In the mortgage origination phase, lenders use FICO® Scores for:
Underwriting: Following submission of the loan application, FICO® Scores are used to finalize loan terms, providing an objective measure to determine creditworthiness and ensure the mortgage loan aligns with the lender’s credit risk guidelines.
Loan Pricing: FICO® Scores allow lenders to efficiently establish and adjust loan pricing to manage risk and margins. Without a standardized credit score, consumers would face uncertainty, potentially going through the entire loan application process only to discover pricing in the final stages. FICO Scores allow for transparent, upfront pricing, giving borrowers the ability to compare offers and make informed decisions.
Insurance Pricing: Insurers rely on FICO® Scores in combination with loan-to-value ratios to set appropriate insurance premiums, ensuring that insurance costs align with the underlying risk.
In the secondary market after origination, investors use the FICO® Score for:
Mortgage-Backed Securities (MBS): Investors aggregate loans into MBS pools based on FICO® Scores, using the score to predict loan performance. This helps provide accurate valuation of these securities, which increases investor confidence and ultimately results in lower costs for consumers due to improved market liquidity.
Pooling Decisions: FICO® Scores are used to determine which loans go into specific MBS pools, ensuring that loans are grouped appropriately based on their credit risk, thereby maximizing returns for investors and driving stability for lenders, which in turn is good for consumers.
Whole Loan Sales: Investors typically will not purchase whole loans without a FICO® Score, as the score provides a benchmark to enable them to price and evaluate credit risk of such loans effectively.
Loan Loss Modeling: FICO® Scores are used to predict likelihood of default, enabling lenders to model and establish loan loss reserves more accurately. More precise reserves mean lower costs for lenders, which are passed on to consumers through lower interest rates.
Mortgage Servicing Rights (MSR): MSR valuation and sales are heavily influenced by FICO® Scores, helping servicers and investors better estimate the long-term value of servicing a loan, which also has downstream benefits for customers through more accurate servicing fees.
For portfolio management, lenders analyze FICO® Scores for:
Prepayment and Delinquency Risk: FICO® Scores help lenders monitor their portfolios for early payoffs and delinquencies, improving collection strategies and return on their investment. This active management also helps ensure the availability of more affordable lending options for consumers by reducing lender risk. For potential investors, the FICO Score is the primary factor in determining the risk profile and cash flow predictability of a loan or pool of loans—accurately identifying pre-payment and charge-off or delinquency risk is critical.
Loan Loss Reserves: FICO® Scores can be used by lenders to assess their portfolios and update loan loss reserve requirements, as appropriate. Loans with higher FICO Scores typically require lower reserves, reducing lender costs and increasing profitability, which translates to lower costs for all borrowers.
The FICO® Score also drives benefits to consumers:
Saves Borrowers Time and Money: The use of FICO® Scores across the mortgage lifecycle ultimately brings many benefits to consumers. By streamlining the prequalification and preapproval processes, it saves borrowers time and helps them quickly determine the best loan products for which a consumer qualifies.
Accurate and Competitive Pricing: Consumers can shop with confidence knowing that lenders utilizing FICO® Scores can more accurately set interest rates using a score that reflects their true credit risk profile. In the secondary market, the liquidity created by MBS pooling and loan loss modeling, driven by FICO Scores, enables lenders to offer more competitive rates and terms to borrowers.
More Money to Loan: Finally, for portfolio management, more accurate analysis can lead to lower loan loss reserves resulting in lower borrowing costs and more capital available to lend to more consumers.
The U.S. mortgage market is one of the strongest in the world, due to its unmatched liquidity and the use of the FICO® Score, which provides a standardized, reliable measure of credit risk. This combination enables efficient lending, investor confidence, and a robust secondary market, leading to lower costs for consumers, broader credit access, and a stable, transparent system that benefits lenders, borrowers, investors, and other stakeholders.
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FICO® Score High Achievers: Is Age the Only Factor?
<p>FICO’s latest research on <a href="http://www.fico.com/en/blogs/risk-compliance/us-credit-quality-rising-the-beat-goes-on/" target="_blank">national FICO® Score distribution</a> shows that US credit quality continues to trend upwards, with an increasing number of consumers scoring in the highest scores ranges. Given that, we decided it was time to refresh our study on “<a href="http://www.fico.com/en/blogs/risk-compliance/infographic-what-does-a-high-credit-scorer-look-like/" target="_blank">FICO® Score high achievers</a>,” where we examine the credit behavioural profiles of consumers with higher credit scores.</p> <p>As expected, our latest study showed that older people generally have higher scores, as has been the case in our <a href="http://www.fico.com/en/blogs/risk-compliance/age-before-beauty-credit-worthiness-before-youth/" target="_blank">past research</a>. This is largely because they have trade lines that have been open longer, which leads to higher scores (assuming the trade lines are in good standing and all other things equal). The most credit savvy among you will remember that length of credit history accounts for roughly 15% of the overall <a href="http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx" target="_blank">FICO® Score calculation</a>.</p> <p>But for younger consumers, it isn’t too helpful to say, “just wait until you are 50 years old, and that will fix things!” Thus, I decided to dive deeper with our analysis, including looking at the credit behavioural characteristics of younger consumers with high FICO® Scores.</p> <p>In this analysis, I looked at credit characteristics for the two highest score bands, 750-799 and 800-850, which have about 16% and 23% of the population, respectively. I further broke this down by looking at the characteristics of the youngest 15% in each group, which occurs at age 29 for the 750-799 group and 43 for the 800-850. We used FICO<strong>®</strong> Score 9 for our analysis, and examined typical variables of the categories that go into the make-up of the score.</p> <p><a href="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png"><img class="alignnone size-full wp-image-29367" src="http://www.fico.com/en/blogs/wp-content/uploads/2016/10/FICO-Score-High-Achiever-table.png" alt="fico-score-high-achiever-table" width="715" height="747" /></a></p> <p>Since there’s a lot to dissect in this chart, I’ll highlight a few findings that struck me: <ul> <li><strong>Credit history.</strong> Higher scores are undoubtedly associated with a longer time on file. What’s striking is the higher average time on file for the 800+ group, both overall and for revolving accounts (the most common trade line). Clearly, it helps to start credit use early in life – but that’s not the sole determining factor for high scoring. The younger cohorts in both the 800+ and 750-799 groups have time on file medians significantly less than their older counterparts.</li> <li><strong>New credit.</strong> High credit scorers do, in fact, pursue new credit. We see little variation in months since last trade line opening and last inquiry among all groups observed.</li> <li><strong>Pay on time.</strong> As you might expect, the further in the past the delinquency, the higher the score – and that’s <u>if</u> a delinquency ever happened. 95% of the 800+ people and 72% of the 750-799 group have never been delinquent, which is a striking contrast to the 57% for the total population. The percentages for the younger groups are even higher, especially so for the 750-799ers. Collection items are also scarce for these high scorers. While 23% of the national population have collection items greater than $99, the figures are only 0.5% for the 800+ group and 3% for the 750-799 group. It is clear that, in conjunction with starting a credit file early, paying on time is a key trait of the FICO® Score high achiever.</li> <li><strong>Balance and utilization.</strong> Finally, we look at how credit is being used, focusing on revolving product use. (Since most people only have one mortgage or one auto loan, variation in instalment product figures is minimal and driven by payment history, which is near perfect for high scorers, as we’ve seen.) FICO® Score high achievers tend to have more open revolving accounts. While the % active trades and utilization are generally lower, by no means do high scorers avoid the use of credit products. What drives the difference here is the amount of <u>available</u> revolving credit utilized. The 800+ group is roughly 1/4 of the national median, both in total and on their highest utilized card; they also have lower balances and more cards<em>. </em>The 750-799 group is more active and higher utilized, but still only at 2/3 of the national figures. The young 750-799 group compensate with lower revolving balances and, as a result, lower utilization, which is in line with what we see for the 800+ group.</li> <li><strong>Benchmarks.</strong> I’d like to point out that while this study provides good benchmarks of the typical credit traits of the FICO® Score high achiever, individual credit profiles will vary widely. And keep in mind that when we sort groups of consumers as a whole by different behaviours, some results may look superficially odd. For example, the 800+ band has a longer median average open account time (128 months) than average revolving months on file (140 months).</li> </ul> So, what do we conclude? A huge takeaway is that high scorers don’t have too much in the way of serious delinquencies and negative public record data.</p> <p>In most respects, the young 800+ people are like their peer group. They really only differ markedly in their shorter credit history and higher non-mortgage balance, both of which are a function of life stage. Our results show that you don’t have to be a credit product hermit; these high scorers have more credit cards. The takeaway is to start credit activity early and maintain well-managed and moderate usage.</p> <p>In many ways, the young 750-799 people are more interesting because their age profile is much younger. Their credit characteristics differ more from their peer group, particularly in terms of length of credit history. They compensate by having almost pristine credit records and lower balances.</p> <p>Ultimately, 39% of US consumers are FICO® Score high achievers, which they accomplish by following common-sense credit practices. It ain’t rocket science!</p>
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