Credit risk, credit scoring, and the performance of home mortgages - includes related information

Federal Reserve Bulletin, July, 1996 by Robert B. Avery, Raphael W. Bostic, Paul S. Calem, Glenn B. Canner

Institutions involved in lending, including mortgage lending, carefully assess credit risk, which is the possibility that borrowers will fail to pay their loan obligations as scheduled. The judgments of these institutions affect the incidence of delinquency and default, two important factors influencing profitability. To assess credit risk, lenders gather information on a range of factors, including the current and past financial circumstances of the prospective borrower and the nature and value of the property serving as loan collateral. The precision with which credit risk can be evaluated affects not only the profitability of loans that are originated but also the extent to which applications for mortgages that would have been profitable are rejected. For these reasons, lenders continually search for better ways to assess credit risk.

This article examines the ways institutions involved in mortgage lending assess credit risk and how credit risk relates to loan performance.(1) The discussion focuses mainly on the role of credit risk assessment in the approval process rather than on its effects on pricing. Although the market for home purchase loans is characterized by some pricing of credit risk (acceptance of below-standard risk quality in exchange for a higher interest rate or higher fees), mortgage applicants in general are either accepted or rejected on the basis of whether they meet a lender's underwriting standards. The article draws on the extensive literature that examines the performance of home mortgages and the way that performance relates to borrower, loan, and property characteristics.

An increasingly prominent tool used to facilitate the assessment of credit risk in mortgage lending is credit scoring based on credit history and other pertinent data, and the article presents new information about the distribution of credit scores across population groups and the way credit scores relate to the performance of loans. In addition, the article takes a special look at the performance of loans that were made through nontraditional underwriting practices and through "affordable" home lending programs.

Delinquency and Default

Delinquency occurs when a borrower fails to make a scheduled payment on a loan. Since loan payments are typically due monthly, the lending industry customarily categorizes delinquent loans as either 30, 60, 90, or 120 or more days late depending on the length of time the oldest unpaid loan payment has been overdue.

Default occurs, technically, at the same time as delinquency; that is, a loan is in default as soon as the borrower misses a scheduled payment. In this article, however, we reserve the term "default" for any of the following four situations:

* A lender has been forced to foreclose on a mortgage to gain title to the property securing the loan.

* The borrower chooses to give the lender title to the property "in lieu of foreclosure."

* The borrower-sells the home and makes less than full payment on the mortgage obligation.

* The lender agrees to renegotiate or modify the terms of the loan and forgives some or all of the delinquent principal and interest payments. Loan modifications may take many forms including a change in the interest rate on the loan, an extension of the length of the loan, and an adjustment of the principal balance due.

Because practices differ in the lending industry, not all of the above situations are consistently recorded as defaults by lenders. Moreover, the length of the foreclosure process may vary considerably, affecting the measured default rate. For these reasons, analyses of default experiences can be difficult and are often based on only a subset of actual defaults. Delinquencies, on the other hand, are recorded contemporaneously and generally on a more consistent basis. Therefore, delinquency data may provide a good source of information for analysis, particularly for evaluating the performance of newly originated loans. and for identifying underperforming loans that require greater attention.

The number of borrowers who become delinquent on their loans is much greater than the number of actual defaults. In some cases, delinquency results from a temporary disruption in income or an unexpected expense, such as might arise from a medical emergency. Many of these borrowers are able to catch up on missed payments (and any associated late payment fees) once their financial circumstances improve. In other cases, lenders work with borrowers to establish a repayment plan to bring payments back on schedule.

Delinquencies, particularly serious ones, are often resolved when the borrower sells the property and uses the proceeds to pay off the loan. Even when the proceeds of the sale are insufficient to fully repay the mortgage obligation, the lender may accept a partial payment to avoid foreclosure. Foreclosure is usually a costly process. Lenders face a variety of expenses, including interest accrued from the time of delinquency through foreclosure; legal expenses; costs to maintain the property; expenses associated with the sale of the property; and the loss that arises if the foreclosed property sells for less than the outstanding balance on the loan. Because foreclosure is so costly to lenders, they may encourage delinquent borrowers to sell their homes and avoid foreclosure even if the proceeds of the sale would not cover the entire amount owed on the loan.(2) This alternative is attractive to many borrowers because having a foreclosure recorded on their credit histories is particularly derogatory and will usually be a significant hindrance in their future efforts to obtain credit.