Credit scores don’t predict mortgage default risk

A new government study shows loans to borrowers with high credit scores are no safer than those to borrowers with low scores.

By Jeff Lazerson | jlazerson@mortgagegrader.com | MortgageGrader.com | May 28, 2021

During the 1990’s, just about everyone, everywhere in mortgage land bought into the powers of FICO scores. From policy makers to ratings agencies, they believed fervently in the accuracy of FICO in determining a borrower’s risk of default.

It never mattered that the FICO formula was a more closely guarded secret than the recipe for Coca Cola syrup.

How did that work out?

An updated May 20 working paper from the Federal Housing Finance Agency, regulator of Fannie Mae and Freddie Mac, offered some stunning conclusions.

Leading up to the 2008 financial crisis, mortgage risk increased across the full spectrum of borrowers, not just those with low FICO credit scores.

Yet, subprime borrowers have been burdened over the past three decades with lousy loan features like prepayment penalties, soaring interest rates, payment adjustments and balloon payments. Meanwhile, mortgage lenders rewarded higher FICO score borrowers with preferred rates and fewer points, believing them to be safer bets.

The FHFA paper reviewed 200 million mortgages issued from 1990 through 2019, estimating a “stressed default rate” for each one. That estimate determined what each loan’s risk of default would have been had it been issued during the start of the 2008 financial crisis.

Subprime borrowers, defined as having credit scores below 660, had a “stressed default rate” largely in sync with borrowers with higher credit scores, the study found.

How many of those 200 million borrowers had higher monthly mortgage payments or were charged more points, processing and underwriting fees?

How many more consumers over the past 30 years were denied homeownership opportunities because their scores were too low? And let’s not forget those with credit files too thin to render credit scores — particularly relevant in underserved communities and lower-income communities.

Before FICO scores – and in conjunction with Fannie’s automated underwriting engine named Desktop Underwriter and Freddie Mac’s Loan Prospector for determining creditworthiness – we in the mortgage business used common sense.

When it came to credit blemishes, applicants were asked to explain and provide a supporting document paper trail. For example, a bad patch of late payment stumbles over a narrowly limited timeline attributable to a serious medical matter could be supported through an independent third party — a doctor’s letter.

Underwriters had some autonomy to make judgment calls. Common sense and credible borrower excuses are null and void in the credit scoring world. A 1-point difference in your middle FICO score would get you denied, all other matters being equal.

Consider the accuracy of the underlying data used to formulate credit scores. On March 24, the Consumer Financial Protection Bureau provided its 2020 annual report to Congress. Credit and consumer reporting complaints accounted for more than 58% of the 542,300 complaints received.

Of the roughly 314,500 credit and consumer reporting complaints, 191,300 were about incorrect credit report information.

On the flip side, credit bureaus long ago stopped reporting tax liens and judgments because of the difficulty in accurately matching the correct credit smudge to the correct person in our privacy-laden era.

Unpaid tax liens and unpaid judgments are a better indicator of a borrowers’ character. This matters when it comes to risk assessment.

Yet, between the credit bureaus and the FICO folks, these behaviors are no longer considered.

Fast forward to the CARES Act forbearance credit reporting kerfuffle. Forbearance protecting mortgage borrowers from damaging delinquencies due to missed payments showed an average 14-point credit score rise, while those not taking mortgage forbearance saw their credit score rise by an average of 7 points, according to a May 19 blog post by the Federal Reserve Bank of New York.

The Fed warned “the concept of the credit score, a device to distinguish good borrowers from bad borrowers, may lose some of its power in signaling creditworthiness to lenders, at least for some time.”

Given this potentially myth-shattering FHFA working paper about FICO scores, where do we go from here?

“This is more of a question for lenders than it is for credit reporting companies,” said Francis Creighton, president and CEO of the Consumer Data Industry Association. “These are questions about how lenders assess risk based on the data.”

Now that the FHFA knows what it knows, at minimum, it should require Fannie and Freddie to end minimum qualifying FICO scores and mortgage price markups for those with low scores. Affordable homeownership could be America’s gain.

Freddie Mac rate news: The 30-year fixed-rate averaged 2.95%, 5 basis points lower than last week. The 15-year fixed-rate averaged 2.27%, 2 basis points lower than last week.

The Mortgage Bankers Association reported a 4.2% decrease in mortgage application volume from the previous week.

Bottom line: Assuming a borrower gets the average 30-year fixed rate on a conforming $548,250 loan, last year’s payment was $59 more than this week’s payment of $2,297.

What I see: Locally, well-qualified borrowers can get the following fixed-rate mortgages with 1-point cost: A 30-year FHA at 2.25%, a 15-year conventional at 1.99%, a 30-year conventional at 2.625%, a 15-year conventional high-balance ($548,251 to $822,375) at 2.125%, a 30-year conventional high-balance at 2.75% and a 30-year fixed jumbo at 3.25%.

Eye catcher loan of the week: A 30-year fixed at 2.875% without cost.

Jeff Lazerson is a mortgage broker. He can be reached at 949-334-2424 or jlazerson@mortgagegrader.com. His website is www.mortgagegrader.com.

* Specific loan program availability and requirements may vary. Please get in touch with your mortgage advisor for more information.