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Finance

FICO’s® New Credit Scoring Method and the Effects on Mortgages

The company responsible for FICO® scores has built a new suite of credit scoring models that will be available by the end of 2020. So, if you’re going to be applying for a mortgage to buy or refinance your home, you should pay attention to the way it’s going to affect your credit score.

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If your two-year timeline includes applying for a mortgage, whether it’s to buy or to refinance, you should pay attention to some fundamental changes that are going to affect the way your credit is scored.

Fair Isaac Corporation, the company responsible for FICO® scores, have built a new suite of scoring models that will be available from all three credit reporting agencies– Experian, TransUnion, and Equifax– by the end of 2020. The suite consists of FICO® 10, which will handle the data it gets from credit agencies in the same way as earlier FICO® releases, and FICO® 10T, which is the first FICO® scoring model to use “trended data.”

Trended Data is a Key Player in the New Changes

The difference between trended data and the current way your credit is scored is a bit like the difference between a picture and a video. Current FICO® models look at a single moment in time. The new FICO® 10T tracks credit and debt activity over 24 months to create a more accurate picture of a borrower’s spending and credit management habits. It will reward borrowers who consistently manage their debt well over time and penalizes those who get their credit in shape when they are applying for a loan and return to bad habits after the loan is approved.

Here are the most critical changes that FICO® 10 makes to the way it will score your credit:

  • Total debt is most important. FICO® 10 gives more weight to the total amount of debt you carry rather than where you put your debt. Moving mortgage from a credit card to a personal loan or consolidating your debt with a low interest card will lower the amount of interest you pay every month, but it won’t reduce your total debt. FICO® 10 is primarily interested in monitoring your credit card balances to see if they are consistently increasing or you are routinely seeking new credit.
  • Consolidating debt doesn’t help. FICO® 10 weighs personal loans more heavily than earlier releases to penalize borrowers who consolidate credit card debt with low interest loans, but then rack up more debt after their scores improve.
  • Delinquent payments will hurt more. Delinquencies on your credit reports occur when you miss payments on your credit obligations. Lenders generally report these late payments to the credit bureaus once you have gone at least 30 days past the due date. Consumers who miss or are late making payments are likely to experience a more severe drop in their credit scores under FICO® 10 than under previous FICO® scoring models.
  • Too much credit card debt will be penalized. FICO® 10 treats different types of debt differently. Revolving credit, such as credit card debt and lines of credit, is a more significant factor in determining your score than installment credit, which includes mortgages and student loan debt. Using credit cards more than other sources of available credit will lower your score more under FICO® 10. If you use credit cards sparingly and avoid large balances, your utilization of credit cards will likely remain low.

What FICO® didn’t change is how it weighs your credit history when preparing your score. The trended data is grouped into five categories:

  1. Payment history which has weight of 35%.
  2. Amounts owed which has a weight of 30%.
  3. Length of credit history which has a weight of 15%.
  4. New credit which has a weight of 10%.
  5. Credit Mix which has a weight of 10% as well.

The new models will deliver two different scores. “FICO® invested in the development of both FICO® 10 and 10T rather than a single score to provide lenders with unparalleled flexibility to select which approach works best for them,” says Ethan Dornhelm, Vice President of Scores and Predictive Analytics at FICO®.

FICO® estimates that lenders who use the new FICO® 10 suite will experience a 10% decline in defaults on new bank cards and a 9% decline in auto loan defaults compared to FICO® 9 scores. Mortgage lenders could see as much as a 17% drop in new mortgage defaults. For consumers, FICO® 10 will be a mixed bag. FICO® estimates that 40 million consumers will see a decrease in their scores by 20 points or more. But another 40 million could see their scores increase by just as much.

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Benefits of FICO’s® New Scoring Models

FICO® 10 examines as much as two years of your credit history, so if you want to be among those whose score will increase, you should start making permanent changes in your debt load and credit management habits now. The earlier you get serious about raising your credit score, the better off you will be under FICO® 10.

Fair Isaac says FICO® 10 delivers more “predictive power” than earlier versions of its credit score. The new scoring models’ goals are to reduce the number of defaults by as much as 10% among newly originated bankcards and by 9% among freshly originated auto loans. “The reduction in defaults is even higher for newly originated mortgage loans, at 17% compared to the version of the FICO® Score used in that industry,” says Fair Isaacs’ press release.

Effects on Mortgages

Mortgages will not be affected by FICO® 10 immediately because home loans guaranteed or backed by Fannie Mae and Freddie Mac, which include the vast majority of mortgages, are still required to use older versions of the FICO® score. When the housing industry adopts the FICO® 10 model, probably next year, homeowners and buyers who planned and changed their credit management habits in 2020 to comply with the changes in credit scoring will be ahead of the game. The first adopters will be Fannie Mae, Freddie Mac and the lenders who do business with them.

When FICO® 10 begins to be widely used by Fannie, Freddie and lenders, owners and buyers who begin to prepare for FICO® 10 now will be glad they did.  FICO® 10T will look back over the past two years of your credit history, so taking steps now to improve your credit will make a difference in the score you receive from trended data.

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Steve Cook is the editor of the Down Payment Report and provides public relations consulting services to leading companies and non-profits in residential real estate and housing finance. He has been vice president of public affairs for the National Association of Realtors, senior vice president of Edelman Worldwide and press secretary to two members of Congress.