The Federal Housing Finance Administration (FHFA) is considering changes to credit scoring models. These changes are aimed at underserved and minority communities to increase the homeownership rate yet will benefit all. Will these changes to credit scoring make you a homeowner?
Why A New Credit Scoring Model?
FHFA first published a Joint Credit Score Solicitation (basically, a request for proposal) back in Feb 2020.
Their goal? To increase homeownership rates across underserved and minority communities. An analysis of US Census data shows current homeownership rates across the country by race, as seen below.
See those two lines at the bottom… the green and light blue lines? Those are the Black and Hispanic/Latino communities and both are below 50%.
I’m not making any controversial statements by noting the clear disparity in homeownership rates. I don’t care about any other specific data – employment, education, marriage rate, values, etc. All we’re talking about here is homeownership rate. Clearly, something isn’t right.
It’s a proven fact that homeownership is a clear path to wealth creation. So how do we increase homeownership levels and lift all boats?
How Is Credit Calculated Now?
According to myFico.com, credit scores currently follow the FICO model which is comprised of 5 categories:
From largest to smallest factor:
- Payment History
- Amounts Owed
- Length of Credit History
- New Credit
- Credit Mix
Payment History (35%)
According to NerdWallet.com, payment history is a record of your payment behavior on all credit accounts, such as credit cards and loans. It is the single biggest factor that influences your credit score.
It includes payments on credit cards, retail accounts like a Kohls card (for example) or Fingerhut, installment loans (like a car payment), finance company accounts, and mortgage loans.
You payment history can also be negatively impacted by things like bankruptcy or wage garnishments or attachments.
They also look at:
- Late payments
- If you’re late, how often you’re late
- If you have any write-offs (When a creditor gives up trying to collect what they’re owed, that doesn’t go away.)
- How much of your credit you’re currently using
- How much you owe across your accounts
- Your on-time payment history
Amounts Owed (30%)
Lenders utilize the amount owed to predict your ability to pay your debts on time. They look at 5 factors:
- The amount owed on all of your accounts – This is pretty self-explanatory. Are you in debt up to your eyeballs? If you are, you’re credit score is probably mediocre at best.
- The amount owed on different types of accounts – Lenders are looking at the mix of your debt. If you owe $20,000, but $18,000 is a car loan and $2,000 is a credit card, that’s totally different than the other way around.
- The number of accounts with balances – If you’re borrowing money from everybody that offers you a loan, that’s probably a bad financial plan.
- Your credit utilization ratio on revolving accounts (credit cards) – In other words, how much of your credit are you using? The magic number is 30% – keep the utilization rate under 30% on any card and in total. Let’s say you have 2 credit cards each with $10,000 limits. On one card you carry a $6,000 balance. On the other card you have no balance. You’re better off moving $3,000 of that debt to the other card.
- The remaining amount owed on installment loans (like car loans) – this demonstrates your ability to pay back loans. If you borrowed $15,000 to purchase a car and you have $6,000 left to pay, you’re proving you can pay back a loan. That’s good.
Length of Credit History (15%)
This is something most people don’t understand, yet it’s really pretty simple ==> Older credit is better credit.
Let me share a personal story to help you understand. My wife and I had a credit card that we got when we were married. We used it extensively over 15+ years and eventually eased ourselves off of credit cards. We switched to paying most everything with cash. When we needed to use a card, we used our debit card. Our credit scores were still very good.
After 2 years of not using that card that we’d had for nearly 20 years, the credit card company cancelled the card. We didn’t get any notice and they would not reinstate the card. We were told we’d have to reapply.
Our credit scores dropped over 60 points.
New Credit (10%)
Don’t go on a credit card application spree. I know the credit card companies send you applications every week and tell you how wonderful you are. Don’t believe them. You may be wonderful but your credit score will take a hit. To lenders, multiple applications may mean you’re hard up for money and they don’t like to lend to people that are hard up for money.
If you’re on the edge of a “Fair” score versus a “Good” score, it could make a big difference in the interest rate you’re offered, which can cost you tens of thousands of dollars over the life of the loan. Nobody likes to pay more than they have to.
Credit Mix (10%)
The credit mix demonstrates to the lender that you can handle different types of loan payments, which is a good sign that you handle your money well.
What Are The Potential Changes To Credit Scoring?
According to HousingWire, FHFA is evaluating whether to switch from the FICO scoring model explained above to another model. One of the models being proposed is the VantageScore model.
Why? Because a newer model is needed to allow access to lending for more Americans. 18% of Black Americans and 15% of Latinos are considered “credit invisible”, meaning they have no credit score.
According to the Federal Reserve, “Credit cards are disproportionately prevalent among those with higher levels of income, those with more education, and among non-Hispanic white adults.”
I could list a bunch of other statistics that continue to drive the point home, but I think you get the idea.
Why does this matter? Because the current FICO scoring model relies heavily on starting off with a credit card to build up your credit score. This then allows someone to access to additional credit from installment loans (like a car loan) to a mortgage. If you never get the credit card, you’re basically denied the opportunity for credit later on.
For the Black and Hispanic/Latino markets, that translates to a lower homeownership rate.
What Are The Disadvantages Of The FICO Scoring System?
Just because someone has a poor credit score does not mean that person is a credit risk.
How can I say that?
Someone may have a 550 credit score in the current FICO model, which would be considered “Poor”. Yet that individual may have rented an apartment for 3 years and has never missed a payment or been late. That individual may also have a cell phone bill that gets paid on time every time.
That person may also live in an urban area and takes the bus instead of owning a car to get around… or that person bought a car with cash and doesn’t have an installment loan to build credit.
Either way, the lack of a credit card and the lack of an installment loan puts that person at a tremendous disadvantage when it comes to a credit score.
Why? Because 35% of the credit score is based on payment history for credit cards, installment loans, and mortgages.
And because 30% is based on amounts owed for those same types of debts that they don’t have access to.
And also because 15% is based on length of credit history for credit they haven’t had access to.
Which means that person is unlikely to qualify for a home loan. And since we noted early on that homeownership is a clear path to wealth creation, the FICO scoring system effectively keeps poor people poor.
How Does The VantageScore Model Hope To Improve Credit Scoring?
The VantageScore model incorporates positive payment history for things like cell phones and rent, to name just a few. This is a tremendous method to increase the pool of credit-worthy borrowers. VantageScore claims that their model provides access to credit for 40 million more consumers.
In addition, VantageScore also take into account the National Consumer Assistance Plan initiative. This provides for the removal of several types of information that may negatively impact a consumer’s credit score (e.g., tax liens, civil judgments, and certain medical collections information) from consumer credit files.
For example, debts that did not arise from a contract or agreement by the consumer to pay, such as traffic and parking tickets or fines, will not be included or appear on consumer’s credit reports. Those types of items stay on a FICO report for at least a year.
These types of thoughtful changes to credit scoring will have a positive impact on homeownership by providing more accurate reporting… and may, indeed, make you a homeowner.
When you’re ready to start looking, you can start your search right here on RyanTalksRealEstate.com.