Mortgage Matters - SunTrust Mortgage

FHA to use FICO scores for risk-based pricing on loan insurance
The FHA plans to shift to a 'risk-based' system tied to credit data to price its mortgage insurance.
By Kenneth R. HarneyWashington Post Writers GroupMay 18, 2008DALLAS -- Who has a better credit score on average -- a home buyer with higher or lower income?Inside the country's fastest-growing mortgage program, the surprise answer is: People with lower incomes have slightly higher FICO scores. That finding, which emerged from a statistical analysis of all approved mortgages insured by the Federal Housing Administration during fiscal 2007, is now buttressing a policy switch that could affect thousands of buyers and refinancers.The FHA, which for decades has used a one-size-fits-all approach to pricing its insurance on home loans, plans to shift to a "risk-based" system keyed to FICO scores and down payments, beginning as early as mid-July. Private-sector lenders and insurers have priced interest rates and premiums using sliding scales of FICO scores and down-payment amounts since the mid-1990s.The agency's move, which will cover new applications including "jumbo" loans up to $729,750 in high-cost markets through December, will bring the FHA in line with the private sector's main approach.Brian D. Montgomery, the FHA's top official, outlined the impending change in a speech here May 8 at the annual conference of the National Assn. of Real Estate Editors. Under the old approach, he noted, buyers with stellar FICO scores paid the same premiums as borrowers with poor scores. That amounted to a pricing inequity for applicants who presented a low risk of default on loans and an inappropriate subsidy of applicants who were likely to default.A study of an entire year's applications turned up the additional fact that the FHA's lower-income borrowers typically had higher FICO scores than those with larger incomes."Is it counterintuitive? Yes," Montgomery said. According to the study, applicants with FICO scores of 680 to 850 had a median income of $48,756 last year, while those with low scores of 500 to 559 had a median income of $53,388. Fair Isaac Corp.'s FICO scores range from about 300 to 850 -- the higher, the better -- and are predictive of future defaults and foreclosures. Even at rock-bottom down payments of 3%, applicants with lower incomes had higher credit scores than applicants with bigger incomes making similar-size down payments.All of which underlines the key reason for making the switch to risk-based pricing: Why should people who have demonstrated superior credit -- irrespective of their income levels -- pay the same mortgage insurance premiums as loan applicants who have seriously flawed credit histories?Under the new system, according to the FHA's outline of its plan, "a larger number of low-income borrowers [will] benefit from premium reductions than . . . moderate-, middle- and upper-income borrowers combined."On 30-year mortgages with down payments of 10% or more, applicants with FICO scores above 680 will qualify for the lowest premiums -- 1.25% of the loan amount upfront and annual renewal premium payments of 0.5%. Borrowers with down payments of less than 5% and poor credit scores -- FICOs ranging from 500 to 559 -- will be charged premiums of 2.25% up front and 0.55% annually. All borrowers will continue to receive the same market-based interest rate. Under the current system, borrowers pay uniform 1.5% premiums upfront and 0.5% annually.To set premium rates by credit standing, the FHA plans to use the middle score of an applicant's three FICOs generated by the national credit bureaus -- Equifax, Experian and TransUnion. If only two are available, it will use the lower. For applicants with thin or "nontraditional" credit histories on file at the bureaus, the FHA will underwrite and price the loans without reference to FICOs, with heavier emphasis on rent and utility payments among other measures of creditworthiness.Although FHA mortgage volume has more than doubled in the last year, the move to risk-based pricing is expected to make it more attractive to buyers and refinancers.During the housing boom years, the FHA lost much of its business to subprime lenders and insurers who offered zero-down, low- or no-documentation loans at high interest rates and fees, including prepayment penalties.The FHA, by contrast, always has required at least a 3% down payment and full documentation of income and assets but has never permitted prepayment penalties.Since taking over as FHA commissioner in 2005, Montgomery has emphasized "modernizing" the agency and winning back market share. That has included pushing for higher loan limits to serve greater numbers of borrowers in high-cost areas such as California and the East Coast.The FHA also is now the government's key vehicle for refinancing borrowers stuck with unaffordable -- and often toxic -- subprime mortgages.