Technology is redefining the way lenders compete and control their costs. In particular, a new generation of advanced automated underwriting tools is transforming the time and manpower that lenders need to evaluate mortgage applications.
Consequently, credit scoring and mortgage scoring have taken center stage in the industry's dialogue on automated underwriting. Unfortunately, these terms are often erroneously used interchangeably.
The difference between credit scores and mortgage scores is substantial, in what they measure and how they can affect the way lenders do business.
Credit scoring came into use in the 1950s primarily to help lenders and retailers process applications for credit cards and other consumer credit lines.
Credit scores are based solely on information in a consumer credit file, like how many credit cards a borrower has, credit card delinquencies, and how often the borrower has declared personal bankruptcy. Such scores were not developed to estimate the risks associated with mortgages.
Mortgage scoring, on the other hand, is the only automated scoring technique available that is specially designed to determine the relative risk of residential mortgage defaults.
"Mortgage score" is a generic term that describes several mortgage- specific products. Comprehensive mortgage scores are more predictive than a score based on only one factor. For example, scores my company offers analyze debt-to-income ratios, loan-to-value ratios, loan reserves, appraisal data, certain market conditions, past delinquencies, and other factors.
In addition to having different definitions, mortgage and credit scores can have markedly different effects on the way lenders do business. Here are just two examples:
First, because mortgage scores are based on so many other factors besides credit history, they are less susceptible to distortions caused by errors in a borrower's credit file.
A number of mortgage brokers at the National Association of Mortgage Brokers' annual meeting in June complained that credit report errors frequently brought down scores and stalled or downgraded transactions with qualified borrowers.
After some brokers suggested that as many as half of all credit reports contained mistakes, the association formed a task force to look at the issue of credit report data problems and credit scores.
Second, mortgage scoring has a special potential to improve secondary- market executions. The Wall Street rating agencies all use some form of mortgage scoring and recognize that the risk of mortgage default may not be captured adequately by a credit score alone.
During the past few months, Fitch Investors Services, Standard & Poor's, and Duff & Phelps Credit Rating Co. have publicly acknowledged that some mortgage scores can assess the probability of default with more precision than a credit score alone. They said that such precision can provide a more accurate assessment of the support a mortgage-backed security needs.
This in turn gives lenders the potential to improve their allocation of resources for underwriting nonconforming loans, obtain better pricing, and give investors new confidence in their securities' underlying loan quality.
Sooner or later, all lenders will look to a scoring system to assess risk better, increase business volume, control costs, and stay competitive.
Secondary market agencies are also pushing the industry toward automated underwriting to reduce loan origination costs. From an underwriting perspective, there is something inherently attractive about moving to an automated system that uses many of the same mortgage, borrower, property, and economic characteristics that underwriters have always relied on to make lending decisions.
As the dialogue over competing automated underwriting systems continues, lenders should pay special attention to the differences between a pure credit score and a comprehensive mortgage score.
Mr. Seaman is executive vice president at San Francisco-based PMI Mortgage Insurance.
