New Credit Scoring Rules to Make Qualifying for Loans Tougher in 2011

Lynette Khalfani-CoxIf you thought it was hard to qualify for loans and obtain credit in 2010, wait until 2011, when lenders start using freshly updated, more rigorous versions of two popular credit-scoring systems.

Fair Isaac, creator of the widely-used FICO score, recently rolled out an enhanced version of one of its key credit scores, the FICO 8 Mortgage Score. This new score may make it tougher for many consumers to secure home loans.Meanwhile, another credit score growing in popularity, the VantageScore, is also undergoing significant modification and will be available to lenders starting in January 2011.

Both credit-scoring systems have been revamped to better account for consumer behavior in the wake of the housing crisis and the Great Recession. Specifically, the two scoring systems have fine-tuned their predictive powers, and now aim to help lenders determine who is likely to engage in a strategic default on a mortgage.

A strategic default occurs when a homeowner who appears to have the ability to pay for their home nevertheless decides to stop making mortgage payments, yet continues to keep up with other financial obligations, such as credit card bills or auto loans.

Homeowners who are under water – meaning they owe more on their homes than the properties are worth – are those who most commonly engage in strategic defaults, mainly because they feel it's not worth it to continue making house payments on an asset that has greatly depreciated.

According to a 2010 Experian-Oliver Wyman Market Intelligence Report, strategic defaults rose 53% in the first half of 2009, to 355,000 cases. Full-year statistics for 2009 aren't available. But previous data from Experian found that 588,000 strategic defaults occurred in the U.S. in 2008, double the level that took place in 2007.

The tricky issue for lenders is that many of these mortgage defaults seem to come out of nowhere, often from borrowers who previously had pristine credit scores.

Enter the world of credit scoring – to help banks better manage their lending risks.

While the fine details of the FICO and VantageScore systems remain a closely guarded secret, some important facets of each are known.

The Recession-Era Credit Scoring Model

When the VantageScore originally debuted in 2006, it was based on an analysis of 21 million credit files over a two-year period. To come up with its new credit score, which is dubbed VantageScore 2.0, the company examined a larger set of credit data across a longer period of time.

VantageScore 2.0 is based on an analysis of 45 million active credit reports. Those 45 million credit files came from 15 million anonymous consumers whose credit histories were examined across all three major bureaus: Equifax, Experian and TransUnion. VantageScore's updated scoring system also now covers overlapping, three-year time periods before and after the recession (from 2006 to 2008, and 2007 to 2009).

As a result, the overhauled VantageScore 2.0 has been dubbed as a "recession-era credit scoring model."

"We've recently experienced a variety of economic scenarios, including an increase in foreclosures in the housing market and changing payment hierarchy among consumers," said Barrett Burns, President and CEO of VantageScore Solutions. "Building VantageScore 2.0 using a blend of consumer behaviors from 2006-2009 produces greater score stability over time."

For consumers, what is perhaps most important about the new VantageScore is that it places more emphasis on some areas of your credit behavior, and less emphasis on other areas.

For example, the single biggest change with VantageScore 2.0 is that shopping around a lot for credit or opening a slew of credit accounts could hurt you far more than it had in the past. Under VantageScore 2.0, recent credit activities – such as filling out new applications for credit – now account for 30% of your score. By comparison, under VantageScore 1.0, inquiries and recent credit activities comprised just 10% of your score.

Likewise, your balances and the length of your credit history are of less significance with VantageScore 2.0. They account for just 9% and 8%, respectively, of your score. In the old VantageScore model, they accounted for 15% and 13%, respectively, of your score.

Preventing Foreclosures, Saving Lenders $1 Billion

For its part, FICO rolled out the FICO 8 Mortgage Score in October 2010.

FICO officials say that this new score is anywhere from 15% to 25% more accurate in predicting defaults than its predecessor. FICO officials also say their new mortgage score will help prevent 115,000 foreclosures in America, saving lenders more than $1 billion.

"The FICO 8 Mortgage Score's broad availability means that all U.S. lenders and servicers can now easily access scores that are fine-tuned for mortgage performance," said Jordan Graham, executive vice president of Scores and president of Consumer Services at FICO. "Moreover, by combining this superior predictive performance with the FICO Economic Impact Service, lenders are able to adjust policies and strategies quickly based upon forward-looking economic modeling. This is what we mean by the FICO analytic advantage: the ability to use the most advanced predictive analytics to compete and win in this highly challenging environment."

And with such a "challenging" lending environment, as lenders start to adopt both VantageScore 2.0 and the FICO 8 Mortgage Score, you can expect it to get a lot tougher to qualify for loans, especially mortgages.

"To do the best job of evaluating risk and increasing profits, lenders need updated credit scoring analytics that incorporate mortgage credit performance since the subprime mortgage meltdown," said Craig Focardi, senior research director at TowerGroup. "The availability of mortgage credit scores across all three credit reporting agencies will enable lenders to upgrade their loan underwriting and account management practices."

In the meantime, if you're in the market for a loan or credit of any kind, now is the time to shore up your credit rating.

As I explained in my book, Perfect Credit, and here in a previous WalletPop column on understanding and raising your credit scores, anyone can improve their credit just by knowing several key strategies.

FICO scores range from 300 to 850 points. The VantageScore ranges from 501 to 990 points. Even though I work diligently to manage my credit wisely, I was shocked to find recently that my VantageScore was a perfect 990. That's practically unheard of. My FICO score, based on my Equifax report, was 798; my hubby's came in at 805.

Haven't checked your credit scores lately? Read my advice on how to get your FICO credit score free.

If your credit isn't where you'd like it to be, and you were thinking about making a financial New Year's resolution, a good goal would be improving your credit rating in 2011.
Read Full Story