If you’ve been in the mortgage business for more than 10 minutes, you’re well aware of the crucial role credit scores play in serving borrowers and getting them into loans.For years there’s been little change in how to calculate credit scores. That's about to change. Savvy mortgage professionals must keep up with new credit scoring changes to assist their borrowers in protecting their creditworthiness. This eBook explains everything you need to know about credit scoring changes and how they’ll affect your borrowers. What You Will Learn Credit Scoring Models While most people are familiar with credit scores, the scoring models that generate them are still not widely understood. What are credit scoring models? The Consumer Financial Protection Bureau (CFPB) defines a credit scoring model as “the mathematical formula used to calculate a credit score from information on a consumer’s credit report.” A credit scoring model assigns weights to items in a person’s credit file. Add these assignments up, and you have the credit score. Is there more than one credit scoring model? Yes. There are numerous credit scoring models. Scoring models exist to predict the likelihood of a person paying their loan back on time. The credit scoring model may differ depending on the loan sought. For example, a mortgage credit scoring model may weigh a person’s credit behavior slightly differently than a credit card scoring model. In addition, different companies provide credit scoring models. The two most notable ones, and the ones used in the mortgage industry, are FICO™ and VantageScore®. Why Do Credit Scoring Models Update and Change?
It’s important to note that credit scoring models are dynamic and can be changed and tweaked, depending on various factors. In the last couple of decades, there have been several small changes to the scoring formula. Why? There are 3 significant reasons.
- Greater accuracy. Lenders rely on credit scores to help predict a person’s creditworthiness. This information is vital in deciding whether to extend credit terms. If there are factors that give evidence to a consumer’s likelihood of paying their loans on time, they should be included in the scoring formula. The more predictive a scoring model can be, the more accurate the credit score is at helping lenders make informed decisions.
- Expanded financial inclusion. Lenders want to serve the widest swath of borrowers possible. Scoring model builders continuously look for ways to score underserved populations, such as consumers who haven’t had credit very long or those who have no credit. If they can pinpoint behaviors that predict a person’s ability to repay a loan, they typically want to add them to the credit scoring formula.
- Decreased delinquency rates. Lenders use helpful tools to assist them in protecting their loans. After all, they want to work with borrowers who follow the loan terms and make their payments on time and consistently. Scoring model changes geared toward painting a more in-depth picture of the applicant’s creditworthiness are essential for minimizing lender risk.
Federal Housing and Financing Agency “Blesses” New Credit Scoring Models
Changing the credit scoring model lenders use in making decisions requires multiple steps.
Integrating New Credit Scoring Models into Lending
First, the model builders must identify, test, and review potential changes to ensure they increase credit scores’ predictiveness. Then, the new credit scoring model must be named and rolled out. After that, Fannie Mae and Freddie Mac must agree to accept the new credit scores. Finally, lenders must adopt the new credit scoring model.
It's curious that some credit scoring models have rolled out in the past, but were never embraced by Fannie and Freddie, which caused lenders to never adopt them.
FICO™ 10T and VantageScore® 4.0
In late 2022, the FHFA announced it would validate the newest credit scoring formulas, the FICO™ 10T and the VantageScore® 4.0 for use by Fannie Mae and Freddie Mac.
Impactful Changes in the New Credit Scoring Model
This change is big for the mortgage industry, as it’s the first significant change in credit scoring calculations in years. The new scoring system sports several key additions from the old model. Here are 4 of the changes found in the new credit scoring models, and how they will affect your borrowers.
#1: Includes Trended Data
The most impactful change in the new scoring models is trended data is now being figured into the credit score. While trended data, which is the consumer’s past 24 months of balance, payment, and credit utilization history behaviors, has been recorded on credit reports for several years now, the data wasn’t calculated into the credit score until now.
Which scoring models are implementing this?
Both FICO™ 10T and VantageScore® 4.0 are adding trended data into their credit scoring calculations.
How this change affects borrowers
The credit scoring models are banking on adding trended data to scoring calculations will significantly increase the accuracy and predictability of determining whether the consumer will pay their loans on time. The overall result will be better decisioning and fewer defaults.
#2: Improved Scorecard Segmentation and Performance
The credit scoring model knows it can’t get accurate results from comparing everyone. Consumers must be segmented. Otherwise, the scoring model would perform well for one set of customers and badly for everyone else.
For example, young consumers with short credit histories can’t be measured against older consumers with decades’ worth of positive credit. That’s why the scoring formulas segment consumers into groups.
Which scoring models are implementing this?
FICO™ 10T and VantageScore® 4.0 made changes to their scorecard segmentation metrics.
FICO™ 10T put additional segments of populations into the scoring formula, which has outperformed previous versions by better-measuring risk assessment.
VantageScore® 4.0 leverages machine learning to score consumers with thin files and short credit histories. Many of these (Vantage estimates 37 million) consumers couldn’t be scored with previous models
How this change affects borrowers
The better scoring formulas are at segmenting populations, the more accurate and predictive they can perform. This change means lenders will most likely see fewer borrowers without credit scores, which is a common hindrance in being able to extend credit More people with credit scores results in more borrowers being approved for loans.
In addition, this change made more minorities credit scorable, enabling lenders to be more inclusive and build a more diverse customer base.
#3: Removes Most Medical Debt from the Credit Scoring Calculation
Medical collections tanking otherwise high credit scores have been frustrating for borrowers for a long time. A forgotten medical bill, often under $100, could tank a person’s credit score and cause them to get turned down for mortgage loans.
The credit scoring model builders analyzed these small medical collection accounts and found they have little predictive bearing on a consumer paying their debt obligations on time. This finding is the reason for removing them from the credit scoring calculation.
Which scoring models are implementing this?
FICO™ 10T has made this change.
How this change affects borrowers
If borrowers have paid their bills on time, managed their credit card debt wisely, and practiced good credit behavior, won’t influence credit scores like before. Removing medical collections from the credit scoring calculation will allow lenders to approve more borrowers for loans.
#4: Adds Rental Payment History
In the past, consumers with few or no lines of credit haven’t been able to generate a credit score. This issue stems from the scoring model needing some type of behavior to analyze, so it can predict future actions. New credit scoring models have begun factoring in rental payment history into the credit scoring calculation (provided rental history is reported on the credit report).
Which scoring models are implementing this?
FICO™ 10T has made this change.
How this change affects borrowers
Figuring consumer rental payment history into the credit score helps FICO™ score many more people than before. Most credit scores equal more loan approvals, helping you serve your borrowers more effectively.
Predicted Results from These Credit Scoring Formula Changes
The model builders expect these tweaks and additions to the scoring formulas to bring about positive results for many consumers.
FICO™ Predicts:
- Mortgage approval rates can be expanded by 5%
- Delinquency rates can be reduced by 17% (for borrowers with 680 or above credit scores)
- Gain up to a 10% predictive lift over previous scoring models
VantageScore® Predicts:
- 37 million more consumers can be scored with the new formula
- 8 million minorities can be scored with a credit score of 620 or above
Timeframe for the Formula Changes to Occur
There’s no “flip of the switch” that automatically turns on the new credit scoring models. The change takes time to be adopted. From a mortgage industry standpoint, new scoring models have no bearing on processes until they’re adopted by Fannie Mae and Freddie Mac.
Since the FHFA validated the new scoring models in late 2022 (as mentioned earlier), we can expect to see the new scoring models integrated into the mortgage industry by late 2023 or early 2024.
Conclusion
Understanding what is changing in the new credit scoring calculations is essential for lenders. By gaining insight into the changes, you can be better prepared to take advantage of the unique and lucrative benefits the new scoring formula provides. In addition, you can share your knowledge with your borrowers to help them become more credit-savvy and elevate their buying experience.
Sources:
https://www.fico.com/en/ficoscore10https://vantagescore.com/lenders/why-vantagescore/our-models/
https://www.consumerfinance.gov/ask-cfpb/what-is-a-credit-score-en-315/
https://www.fico.com/en/resource-access/download/42031
https://vantagescore.com/wp-content/uploads/2022/09/4.0-Fact-Sheet-UPDATE-Sep-2022.pdf
