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Have mortgage underwriting standards become too strict?

Recently, Zillow.com questioned the tight loan requirements now in vogue among mortgage lenders. The company, an online marketplace where borrowers shop for mortgage rates and loans, says the tougher criteria "keeps a cap on housing demand, which is important for the greater housing market recovery."

Certainly no one wants a “recovery” to the Wild West mortgage market that preceded the financial crisis. But has the pendulum swung too far the other direction?

Zillow notes that nearly 30% of US consumers have FICO® Scores below 620—scores that US lenders consider too risky to qualify for standard mortgage loan, even if consumers offer a healthy 15 to 25% down payment. These standards are tighter than the published guidelines of FHA or the GSE's.

It's understandable that lenders are taking a conservative approach, given today's high foreclosure rates and skyrocketing origination costs. But one of the key lessons of the financial crisis was the need for a healthy balance between risk management and growing revenue. Hopefully it's a lesson that won't be lost when the mortgage market does indeed return to growth.

To ensure that balance, lenders should invest NOW in two credit risk essentials. The first is consumer credit education. We all benefit from consumers who engage in credit-building activities and know how to manage credit, even when times get tight. Lenders should encourage customers to take advantage of credit education resources like myfico.com, budgeting tools and credit counseling services. They'll build long-term customer loyalty by being a friendly, educational lender and consumer advocate.

Secondly, lenders must uphold smart risk management practices. These include regular monitoring of portfolio performance by score, vintage and local economic factors, as well as using the best risk assessment tools, such as:

  • Strongest credit risk scores. Scores have the most value when they are produced by newer scoring models developed from recent consumer credit data and incorporating leading edge analytics. If possible, the scores also should predict performance that is aligned closely with the lender’s business goals. If a lender makes home loans, for example, it should use a score such as the FICO® Mortgage Score that predicts the risk of mortgage loan default specifically.
  • Economic adjustors. These analytic tools can help lenders quickly adjust decisions in anticipation of changes in macro-economic conditions. By doing so, they can take advantage of opportunities in an improving market or consumer credit segment, or get greater control over portfolio performance and profitability. Solutions such as FICO® Economic Impact Index help lenders protect profit while confining risk to acceptable levels.
  • Credit capacity measures. These tools help lenders distinguish between two applicants with identical credit scores, based on their respective capacity to safely take on new credit. Stated income and income estimators have proven to be significantly less reliable as risk indicators than empirically developed analytic tools such as FICO® Credit Capacity Index™.

Today’s frozen credit market will eventually thaw. When it does, lenders that invest in smart risk management practices and credit education will find themselves ahead of the game.

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