What Is A Credit Score?
When a lender evaluates a loan application, a process called underwriting, they try to evaluate the ability and willingness of the potential borrower to repay the loan. The application the borrower fills out is sent to an underwriter, who is a real person and not a computer program. The underwriter then judges the borrowers ability to repay by reviewing the income and stability of past earnings. This practice helps the lender to determine if the borrower can afford the loan payments. The review of past credit history is used to judge the willingness of the borrower to repay the loan. This is the reason you are required to produce so many documents to substantiate your income when you’re filling out the loan application.
Lenders want this evaluation to be as accurate, objective and consistent as possible. To help achieve this goal, home mortgage lenders use credit scores to assist in the underwriting process. Credit scores are numerical values that rank individuals according to their credit history at a given point in time. A credit score is based on past payment history, the amount of available credit, and other factors. According to Fannie Mae and Freddie Mac, two largest investors in mortgage loans today, credit scores have proven to be very good predictors of whether a borrower will repay his or her loan.
Credit scores are just one of many factors considered in the underwriting process. A lender will review all of the components that make up the financial situation of each borrower. Even when a credit score is low, there are other factors that could overcome the negative credit issues and satisfy other underwriting criteria. Today, FHA loans are filling the bill for people with low credit scores, less than 20% for a down payment or perhaps other reasons that make this loan enticing since it only requires 3.5% for the down payment.
What is a FICO Score?
“FICO” scores are a type of credit score developed by Fair Isaac & Company. FICO scores use credit bureau information to obtain a score which indicates how likely someone is to pay their loan payments on time. FICO scores range from approximately 350 to 900. The higher the score is the lower the probability of default on the loan.
How Can Credit Scores Affect the Price of the Loan?
Just as credit scores are one factor in determining loan qualification, they may also be a factor in determining the price of the loan. The price of a loan means the interest rate and the points charged by the lender. The price charged for a loan will be higher or lower depending on various factors.
Credit scores are used in determining the price of a loan because they are believed to be good predictors of a borrowers ability, and willingness, to repay the loan. Because of this, applicants with lower credit scores will pay higher prices for their loans because of the higher risk of default and loss on the loan. Many home loans are sold to investors, and investors will pay a more favorable price for loans they feel have a low risk of default.
There are lots of other factors relating to an individual borrowers situation that may also affect the price of a loan, often even more than credit scores. These include the type of property securing the loan, the amount of the borrowers equity in the property (meaning your down payment), the value of the property compared to property value in the area, the lenders cost to make the loan and the type of loan selected. For example, a loan secured by a single family residence will have a lower price than a loan secured by a condominium because condominiums are more difficult to sell than single family houses. Likewise, the price of a loan for which the borrower has made a 20% down payment may be less than a loan for which the borrower has made a 3.5% down payment because the first borrower has more equity in the property and, thus, a greater incentive to make the payments of the loan.