First seen in the auto loan and credit industries—and most recently in the area of home financing—automation and credit scoring now are poised to sweep through small-business lending.
It seems as if just about all areas of lending have been revolutionized by these systems, which offer the promise of improving the lending process for all those involved. The lender is able to get the job done faster and with better risk predictability; the consumer benefits from lower prices and immediate results. Many consumers and community development professionals, however, have concerns about the effect of credit scoring on access to credit. So, what are automated underwriting and credit scoring?
Lenders using an automated underwriting system enter a borrower's application information into the system. Additional information on the applicant is collected from credit reporting agencies. The automated underwriting system then weighs all this information to determine the likelihood that this loan will repay as agreed, based on the way similar mortgages with comparable borrower, property and loan characteristics have performed in the past. Automated underwriting systems assess the riskiness of the loan based on a comprehensive evaluation. Lenders using such systems are able to make faster and more accurate loan decisions, and, by consistently applying uniform standards of creditworthiness, automated underwriting systems provide the same objective treatment of all borrowers.
Automated underwriting systems use credit scoring as a scientific way of measuring the relative amount of risk a potential borrower represents to the lender or investor. A credit score is a number that rates the likelihood an individual will pay back a loan.
One of the most widely used scoring models was created by Fair, Isaac & Co., whose scores are known as FICO scores. FICO scores range from approximately 400 to 900. The lower the score, the higher the risk for the lender or investor. In a survey of one million loan records, Fair, Isaac found that one in eight borrowers with a FICO score below 600 was either severely delinquent or in default. In contrast, only one in 1,300 borrowers with a score above 800 had similar delinquency problems..
This strong evidence of predicting delinquencies has prompted major secondary market investors Fannie Mae and Freddie Mac to encourage lenders to use credit scores as a regular part of their manual underwriting. They have recognized the use of credit scores as a valuable tool in evaluating credit risk. Both Fannie Mae and Freddie Mac also have endorsed certain "cutoffs." Both have said that a FICO score less than 620 would indicate a need for a cautious, detailed review of a borrower's credit history in order to identify compensating strengths to offset the low credit score.
The use of automation and credit scores has the potential to help bring more borrowers into the housing market. By speeding up loan approvals for borrowers with good credit scores, automated systems give underwriters more time to work with borderline borrowers. And by applying uniform standards when evaluating a borrower's credit profile, credit scores can help ensure a level playing field that should have a beneficial impact on the number of minority homeowners. As the use of credit scores moves into the small-business lending industry, these same benefits can affect the volume of such loans and mean greater access to credit for small-business owners.
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