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Why millions of prospective borrowers are stuck in ‘no man’s land’

In the wake of 2020, uncertain income equals tightened underwriting standards

The White House’s March jobs report showed encouraging job growth one year after the first pandemic-related unemployment claims. Still, the Biden administration says the economy remains down nearly 8.5 million jobs year over year. It’s expected to take at least through the end of 2021 — and maybe a lot longer — to get back to pre-pandemic levels.

That means there are still millions of unemployed Americans, and when employment is uncertain, so is income. Uncertain borrower income spells risk for lenders and investors, who tend to respond by tightening their underwriting guidelines. This seems sensible — but it also has unintended consequences.

The credit box has tightened to the point where the average FICO score for all loan types is north of 750, according to ICE Mortgage Technology, and we know of several lenders whose credit overlays require applicants to have closer to a 780. Meanwhile, the average U.S. FICO score is about 711. The discrepancy between these figures tells us that average prospective borrowers — including the majority of Black and Hispanic households — are being squeezed out of the credit box and missing out on the lowest mortgage interest rates in history.

That’s a disconcerting notion for anyone who’s serious about paying more than lip service to the mission of helping Americans achieve the dream of homeownership. Moreover, it’s bad business; when lenders curate their pipelines to the point that they’re only writing loans for “the best borrowers,” they can expect to see razor-thin profit margins and high borrower turnover. After all, someone with a credit score of 780 can get a loan anywhere, anytime — which is exactly what they’re apt to do every time rates move a quarter of a percent.

The mortgage executives I’ve been speaking with are asking themselves, “what am I going to do later this year and in 2022 when rates tick up and cookie cutter refis are no longer falling from trees?” Those who don’t want to spend $1,500 a lead to fill the gap with extra purchase loans are going to have to open their credit boxes back up. Certainly, one path for doing so is to enter the non-QM lending space, but the tradeoff is that non-QM loans are more expensive to originate and difficult to sell. The path of less resistance is to peel back credit overlays in order to underwrite more Qualified Mortgages for delivery to the GSEs. The question, then, becomes how to do this without introducing greater risk.

One category of risk lenders need to avoid is good, old-fashioned fraud, and let’s be frank: bad actors come out of the woodwork in times of economic stress. There was a fascinating story that made headlines in FormFree’s own backyard last month when 11 metro Atlanta residents were charged in a mortgage scheme that defrauded several marquee mortgage lenders as well as home-building giant D.R. Horton. I can think of no more perfect story to illustrate the criticality of lenders replacing paper-based documentation of assets, income, unemployment with the kind of direct-source data FormFree pioneered more than a decade ago.

More generally, though, what lenders need is a better way of assessing a borrower’s ability and willingness to repay a loan. A FICO score viewed in isolation, especially in times of socioeconomic instability, is imprecise; not all borrowers with a credit score of 700+ will behave well, and by the same token not all 600s are risky. 

By supplementing traditional FICO scores with additional consumer financial data such as assets, income, employment and liens and judgments data, lenders can identify understated or overstated FICOs and gain a more holistic, data-driven assessment of each borrower’s willingness to pay. Armed with this information, lenders can improve both volume and margin by originating not just more loans, but more profitable loans. 

Safely extending credit to borrowers within this segment doesn’t just create revenue opportunities for lenders; it also promotes greater financial inclusivity. According to the Urban Institute, “Black households have the lowest median FICO score among all racial and ethnic groups and the greatest share of households with no credit score at all.” Hispanic households fare only a little better.

We have the tools to serve an entire segment of prospective borrowers — including, disproportionately, people of color — who are “stuck in the middle” between the agencies’ minimum FICO requirements and the “FICO gates” imposed by lenders’ credit overlays. We just have to use them.

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