Monday, March 25, 2019 / by Skye Leber
A major reason Fannie Mae and Freddie Mac lenders are willing to make immediate loan decisions is credit scoring. Credit scoring uses statistical samples to predict how likely it is that a borrower will pay back a loan. To develop a model, the lender selects a large random sample of its borrowers, analyzing characteristics that relate to creditworthiness. Each of the characteristics is assigned a weight, based on how strong a predictor it is. Credit scores treat each person objectively because the same standards apply to everyone. Credit scores are blind to demographic or cultural differences.
Credit scores are used for purposes other than loan qualification. Insurance companies evaluate risk based on credit scores. Sometimes, people find it hard to get insurance because low credit scores have been associated with higher claims experience. Because people with higher scores seem to have fewer claims, their rates are generally lower. Many companies use credit scores in their hiring process. Partly because the recession damaged the credit scores of people who lost their jobs or defaulted on their mortgages, some states have passed laws that don't allow the credit scores to be a factor in the hiring decision.
The most commonly used credit score today is the FICO score. FICO scores range from 400 to 900. Low scores predict that the borrower is more likely to default on a loan.
Interestingly, each person has several credit scores for the FICO scoring model, because each of three national credit bureaus, Equifax, Experian, and TransUnion, have their own databases. Data about an individual consumer can vary from bureau to bureau.
A person's FICO score consists of the following components:
- Payment history—35% of the score is determined by payment histories on credit accounts, with recent history weighted a bit more heavily than the distant past.
- Debt utilization—30% is based on the amount of debt outstanding with all creditors as a percentage of the total available credit limit.
- Credit history—15% is produced on the basis of how long the borrower has been a credit user (a longer history is better if there have always been timely payments).
- Recent credit searches—10% is comprised of very recent history and whether the borrower has been actively seeking (and getting) loans or credit lines in the past months.
- Types of credit—10% is calculated from the mix of credit held, including installment loans (like car loans), leases, mortgages, credit cards, et cetera.
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Information courtesy of Continuing Education Bob Hogue Knowledge Hub 2019