Credit Scores and your HELOC

While we really do not like the control that the credit scores have over people's lives. It is like mysterious black box that can affect almost every aspect of people's lives. The credit scores can affect how much you pay for everything, influence the home purchase or rental, even getting a job.

We have, in the past, hoped for some type of regulation for the credit score industry. Since different lenders can supply different standards for the same activity. Or people can have their credit score dinged through absolutely none of their own doing. And do not even get us started on the complexities of trying to fix something that is wrong with a credit score - it can easily become a full time job.

Now we see that you have to play HELOC games so as not to ding your credit score. Open your HELOC for 3 times the amount you plan to use or watch your credit score get hit. In this article titled Treat delicately before tapping HELOC - it could damage your credit from the Orlando Sentinel we see the complexities involved. Let's take a look -

I have heard from some of my sources who work for credit card companies that the federal government is requiring lenders and creditors to have cash on hand equal to, in some cases, 40 to 50 percent of the credit that has been extended in the form of available credit on a credit card, or a home equity line of credit (HELOC).

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For example, if you have a credit card that you haven't used in 12 months, the lender may close it or reduce the amount of total available credit. We're hearing from thousands of Americans who have had their home equity lines of credit reduced or closed. Not only does this make it difficult to access the credit you've so carefully preserved, but it will also tarnish your credit score.

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If you don't take money out of your credit line, you may be one of those who ends up having the credit limit cut and later regret that you didn't take the money out when you could. But taking a sizable amount of money without the means to pay back the funds can put you in a precarious situation.

Let's think about how this would play out: If you tap 80 to 90 percent of your line of credit, you will hurt your credit score at least a little. But if your credit line is cut substantially, that too might hurt your credit score, as you'll have less available credit.

Optimally, you'd never tap more than 25 to 30 percent of a line of credit ... Anything more than that could lower your score a little, depending on other factors in your credit history. But since you might actually need the cash, it's better to take it now rather than want it later and not be able to get it.

The credit score is a messy area - and it is probably getting messier with the economic downturn. It is in desperate need of standards and regulation. Having access credit but not using it could harm your credit. Use your credit - but get the amount available reduced also harms your credit score. Not having enough credit activity or history also affects your credit score. It all seems so counter intuitive. But that is the way credit scoring works.

FICO Score Concerns

With the credit drying up and lenders reducing the amount available some of the FICO procedures are causing problems for even the best of consumers. While the full FICO methodology is a proprietary secret, we do know that part of the calculations are based on the amount of credit used as a percent of the consumer's available credit. So when a lender arbitrarily halves your credit card limit a ding will be left on your credit score. And since most of the universe seems to revolve around the FICO score - from auto insurance to potential employment - a couple dings from lenders could create real life problems for many people. Today we find we are not alone in our FICO concerns with this post titled Freedom From FICO over at SavingAdvice.com. Lets take a look -

One of the benefits of a life without debt is (some) freedom from the gods at FICO. Because I don’t do debt, my FICO score is not as important to me as it is to some and that takes a lot of worry out of my life. I see many people freaking out about their FICO scores because they know they will need a loan in the near future.

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And it’s a good thing that I don’t worry about it too much. Just the other day, I got a notice from a credit card that they were lowering my limit. ... More and more credit cards are closing cards and lowering limits and even the debt free are not immune to the madness. My score will no doubt drop a few points in the coming months, and not because of actions I take. But I can live with it.

I know many people who are at their wits end because their scores are dropping through no fault of their own as credit lines are slashed and even eliminated. This practice dings the all important “utilization of debt” ratio that comprises a large part of a credit score. When you have lower credit limits and your outstanding debt creeps closer to the maximum, your score goes down. And it’s happening all over the country right now. Some people, desperate for a car loan or a home equity loan are being denied because their scores have dropped, even though they have done nothing to deserve it. It’s cause for concern if you require debt to get through life.

I don’t agree with FICO’s methods for determining a score and I don’t agree with the way a lot of insurance companies, employers, and others use the score to determine who gets what. It’s a flawed system that takes away the human element and places all the control on a computer algorithm that has no concern for you as a person, your special circumstances, or that the credit card companies jacked you around. But it’s the system that the world uses and, like it or not, they’ve managed to make it so that even those of us who don’t use debt have to concern ourselves with this score.

It does seem pretty scary how one company can have so much influence. And since the algorithms are trade secrets it can be even more worrisome. We hope they have layers and layers of securities in place - even from their own employees. One mad FICO employee doing some random havoc could ruin numerous people's lives. With great power comes great responsibility. Oh, that is not working out so well for our best and our brightest. Let's hope things are better in Minneapolis then on Wall Street.

Credit Games

Things we know - those with lower credit scores pay higher interest rates. Using up more of your available credit lowers ones credit scores, which will then bump up interest rates. Lowering available credit makes your current used credit larger in relation to available credit which can bump up your score. See, all that has to be done is lower available credit, which may lower credit ratings below that magical 750 threshold to raise interest rates. It basically looks like anything (or nothing) one tries to do - other than keep make keeping up with their credit score a full time job - will negatively impact one's credit score. This article from the News Tribune titled Banks' shifting credit terms can hurt your score explains it all. Let's take a look -

As the worldwide credit crunch has hit home in the form of reduced credit-card limits and home-equity lines, not all of this curbing is fair. In many cases, you may be targeted by zip code or other invisible criteria.

It’s not hard to get steamed about their spurious practices. Card issuers can legally raise or lower your limits and terms at any time. Most cardholders don’t know how to fight back and get better terms.

If banks clip your credit limit, it can hurt your chance to borrow at the best rates, especially if your record is spotty or you are a small business.

The chill is reaching consumers as banks are expected to cut credit lines by some $2.7 trillion, according to Meredith Whitney, a well-known Wall Street banking analyst. Some $2 trillion out of $5 trillion available may be “removed from the system by the end of 2009.”

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The bottom line in personal credit is to maintain the highest credit score possible. While there are several scoring systems, the best known is the FICO program. Unfortunately, the details of how credit bureaus calculate scores, mostly determined by Fair Isaac Corp.’s system, are a trade secret.

Generally, any FICO score of more than 750 translates into the lowest finance rates on everything from cars to mortgages. But a good credit rating means some maintenance on your part, and some of the advice is counterintuitive.

For many it is a lose-lose situation. With the tightening of credit goes the lowering of credit scores. With the lowering of credit scores goes the tightening of credit. Pay more and get less. Our whole system seems to run on FICO - yet everything they do are trade secrets. One company that is not accountable has a lot of power over our lives...

The Credit Score Glitch

Everyone relies on FICO - but there are glitches. We have noted before the lenders choice of reporting and coding can actually have a bigger impact in your credit score than the actual activity by a consumer. For instance a short sale can have a bigger impact than a foreclosure depending on how things are coded. This seems to make no sense. Now we learn that banks randomly deciding to close inactive accounts or trying to reduce exposure so they lower the amount available. This can drive down a person's credit score through no fault of the borrower.

So a lenders arbitrary decisions - that have nothing to do with the lenders activity, influence or decisions can have a huge impact and possibly affect things like jobs, rental decisions, and everything in between. Then we hear that credit scores are basically a black hole determined by Fair Issac and a few others. This gets pretty scary how much how company - not really accountable or regulated can have on a person's life.

This article from the USA Today shows how the falling economy is revealing some of the problems of the current credit scoring procedures. The article is titled Sliding economy raises questions about credit scores. They may not be the most respected news organization in the country, but we have to acknowledge the good investigative reporting USA Today has done on the credit crisis. Not lets take a look at the article -

Banks and lenders are shoring up risks — closing a record number of credit card accounts and reducing millions of dollars in credit lines. As they clamp down, even some consumers with excellent credit and spotless payment records are seeing their credit scores reduced because of the diminished credit lines. That, in turn, can hamper consumers' ability to get credit elsewhere.

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The cycle concerns consumer advocates and some legislators. Some wonder whether restrictions should be imposed on lenders' ability to slash credit limits and close accounts. And if scores can drop even if consumers do nothing wrong, they say, it raises the question of whether there's a flaw in the credit scoring formulas relied upon by the nation's lenders, insurers, and increasingly employers and landlords.

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Bank officials also say they have no control over credit score calculations — and, like consumers, they don't know exactly how such scores are determined.

"It's tough to connect any one action (by the lender) to consumers' credit score," says Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, which represents large banks.

Even so, banks are concerned enough about the issue that they've asked Fair Isaac, the creator of the widely used FICO score, to study whether — and to what extent — their tightening of credit affects scores. Fair Isaac plans to complete its preliminary study in the next few weeks.

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Seth J. Chandler, a law professor at the University of Houston, says although credit scores are "incredibly powerful, lenders might start to revise the importance they put on (them) if they no longer reflect reality."

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Fair Isaac and the credit bureaus don't disclose exactly how credit scores are calculated. But a key factor in the score is what the industry calls "open to buy," basically how much of a consumer's credit line is drawn down on plastic. Also called the credit utilization ratio, this — along with a handful of other variables — makes up a combined 30% of your FICO score, Fair Isaac says. Other important components include overall payment history, how long a consumer has had credit, and the types of credit.

When lenders close accounts or slash credit limits, it often boosts the percentage of available credit consumers are using. That's the key reason scores could fall.

We have given a huge amount of control to one company. The article further states that -

Today, 90 of the largest 100 financial institutions rely on FICO scores, according to Fair Isaac. Credit bureaus also sell proprietary credit scores, and team up to put out the VantageScore, a competitor to FICO.

FICO has a lot of control. While there is little control and understanding about how credit scores are derived. Yes we know the basics, but even bankers acknowledge they do not know the specifics.

Imagine how much damage and problems FICO has can have on the country if something goes wrong. Could one lethal computer virus at FICO could damage the country? Or the financial World? When we are seeing the havoc a few large companies can have when they dominate the markets, it is surprising there is not more regulatory pressure on FICO.

Perhaps this USA Today article will help bring some guidelines, industry wide procedures for something that affects so many but is only understood and controlled by a few.

Just when we thought things could not get any scarier, they do.

Foreclosure and Short Sales Impact on the FICO Score

Here are the FICO issues regarding walking away, foreclosures, and short sales in New Jersey. The FICO results are not as straight forward as you may think. The lenders have alot of latitude about what they report and how they classify it. Short sales may harm your credit score as bad as a foreclosure. With all the other burdens of a short sale, this just adds to the arduous aspect of such a deal. Why bother negotiating if your credit will get hit just the same? Well lets take a look at the FICO side of Sundays Real Estate section with an article titled When you can't go home again -

The biggest problem with walking away from your home and hastening foreclosure is that foreclosure is a huge blight on your credit score: a drop of perhaps 200 or more points on your FICO credit score. (A strong FICO score is around 700 and above.)

Still, if you have already missed a half-dozen or more mortgage payments as Bob and Sharon have, your credit score has probably already taken a big hit.

"Anybody that I talk to who even contemplates walking away from his home, I lay out a number of reasons they shouldn't," said Re/Max real estate agent Sal Poliandro. "A short sale is a way to get you out of your predicament with dignity. It helps the bank get rid of an asset before they come and collect it. When we talk about foreclosure, it's not just a financial thing. As far as credit goes, nothing will ever cost you the same. You're going to have to pay $600 a month for a car, rather than $300 a month. And, with a foreclosure, your name will be in the paper."

And foreclosure can be postponed, Poliandro said, while short sale negotiations are under way.

However, short sales may show up on credit reports as "pre-foreclosure in redemption status," which can seriously hurt the seller's credit score as well.

Craig Watts, public relations director for Fair Isaac Corporation, which created the FICO scoring system, said in an e-mail: "The effect on a FICO score is likely to be very similar for both actions [foreclosure and short sale]. The impact depends on how the lender chooses to report the foreclosure or the short sale to the credit bureaus."

A foreclosure remains on a mortgage-holder's credit report for seven years. But the FICO Web site says, "While a foreclosure is considered a very negative event by your FICO score, it's a common misconception that it will ruin your score for a very long time. In fact, if you keep all of your other credit obligations in good standing, your FICO score can begin to rebound in as little as two years."

Funny that the Re/Max real estate agent is giving foreclosure and financial advice??? And that the FICO guy basically contradicts everything the Re/Max agent says. First thing to note - do not take any financial from a real estate agent, ever. To become a realtor in New Jersey you just need 75 class hours and passing an exam. No college required either - and yet dispensing some of the most important financial advice one may face in their lives. This ought to be illegal!


From the State of New Jersey website -

What are the qualifications for a Real Estate Salespersons license?
To qualify for a Real Estate Salespersons license you must be at least 18 years old, have a high school education or equivalency, complete a 75 hour pre-licensure course at a licensed school and pass the New Jersey examination. After passing the examination, you must apply for a license through a sponsoring Employing Broker within 1 year from the expiration of the school certificate or you must again complete all requirements.

So what have we learned from today -

1. Don't take financial advice from a realtor! You may as well be taking financial advice from the guy next to you at a bar or the woman next to you at the salon. Or maybe the cashier in the grocery store - they are in sales too! And they deal with money all day!!!
   
2. Your credit score may be harmed the same either through foreclosure or short sale.
3. If you choose foreclosure rather than a short sale your name will appear in the paper (in an obscure section that no one will read other than people looking to get a good deal) and this could be devastating!
4. Talk to a lawyer or a financial planner to help with your decision and issues - not a realtor!
5. We need a state-wide push to make realtor's giving financial advice to their clients illegal!
   

Walking Away in New Jersey

Other than the hit to one's credit score walking away sounds so easy. Unfortunately it does not appear to be as easy in New Jersey as it is in other states. Their is a push that a short sale is better than foreclosure, but the process is cumbersome and may have just as big of a negative impact on your credit score. For those underwater their is no solution that is not going to be painful.

Sometimes just getting out heals enough pain to help the owner, soon to be former owner, able to keep getting by. That appears to be the feature story in this Sundays Real Estate section with an article titled When you can't go home again. We were pleasantly surprised to read a positive story regarding someones decision to leave their property. The article has lots of important information for those that New Jerseys' foreclosure mediation program can not or will not help. Lets take a look at the article -

[Sharon] loved the [Oakland] house where she had lived for 30 years and raised her children. But when she and her second husband, Bob, refinanced the house in 2005 to pay college tuitions and buy out Sharon's ex-husband's stake in the home, they unwittingly set off a chain of circumstances that would lead them to abandon their home and move into a rental little more than three years later. It was a $350,000 adjustable-rate, interest-only loan they had applied for over the phone.

"We started getting letters that our mortgage payment was going to increase by $600 a month come January of 2008," said Bob, who along with Sharon asked that their last name not be used. "And that payment was going to keep going up and up and up. I tried to refinance, but there wasn't enough equity to refinance."

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Bob and Sharon's decision to abandon their home is not so extreme as those who walk away from houses worth less than the mortgage and mail the lender the keys. The couple hasn't made a mortgage payment in eight months or so, but the house is listed for sale, and Bob pays to keep the utilities on. He visits once a week to check on things and shovel snow from the drive and walkways.

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There are few statistics on how many people abandon homes when they can no longer afford the mortgage payment and the house is worth less — often significantly less — than the mortgage. There are now a number of Web sites offering advice — for a fee — to help struggling mortgage-holders "walk away" from homes that are no longer worth the investment, sites such as youwalkaway.com, walkawayplan.com and mortgagedefaultlegaltrack.com.

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"People try to talk about the homeowner's ethical decision and moral responsibility [to pay what he owes]," said [Jon Maddux, the CEO of the California-based Web site YouWalkAway.com]. "But banks look at it as a business decision. You have to do what's best for the survival of your family."

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Bob and Sharon are relieved to be in their new home. They are paying their bills on time, and working to rebuild their credit. Sharon treasures a birdhouse, made by a friend's father, that is a replica of the home where she lived for three decades. Bob worries that there could still be financial repercussions, that someone might come and garnishee part of his paycheck to pay down the unpaid mortgage.

Relieved to be out from under the economic pressures of an ever changing ARM. Happy to have left a home that become a huge burden. Leaving the home and rebuilding the life is a fresh start that can help ease the pain and burden of the foreclosure. We are glad an article featuring people landing on their feet after foreclosure. Note that the morality is only imposed on the borrower side of the transaction. As the morality issue changes, and it will as the numbers of foreclosures rise, there will be little negative impact aside from hurt credit for those leaving an underwater property.

Finally, since the article was so long and involved different aspects of the walking away, foreclosures in the next post we will look at the credit score issue.

HELOCs And FICOs

One big issue regarding the lenders arbitrarily freezing of HELOC lines is the impact they can have on an individuals credit score. A line opened with $100,000 could easily be reduced by half or more.. and what happens to people when they are at the cutoff point? Since they are now at the 100% credit utilization level what impact will that have on their credit score? Today we find out from Florida's New 12 with their online article titled Clean up your credit. Lets take a look -

With all the financial upheaval over the past year, including the subprime-mortgage mess and the rescue plan for banks toppled by risky loans, it wouldn't be surprising if you were tempted to think that credit is a four-letter word.

But one important lesson this crisis has driven home is that your credit is the financial equivalent of your good name. A good score is your ticket to a home, a car, a credit card or even an insurance policy, and even a tiny slip-up can come back to haunt you. That's especially true now because the credit crunch has spread to other types of borrowing. For instance, banks have been forced to write off record levels of credit-card debt, so they're setting the bar higher for potential borrowers. A year ago, a score of 720 would have had lenders lining up for your business. Today, a score of 740 or 750 will get you an account but might not qualify you for the lowest interest rates, says Bill Hardekopf, of LowCards.com.

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Other things to watch out for: paid-in-full accounts that still show a balance and someone else's record that appears in your file. If the credit bureau misspells your name or reports your address incorrectly, that won't affect your score. Balancing act. It's important to minimize the ratio of your outstanding debt to your credit limit (what's known as your credit-utilization ratio) for each card you hold. If you're near your limits and a long-standing customer with a good history, you could ask your current card issuers to raise your limits. Or you can focus on paying down your balances so that you're using less of your available credit. A good rule of thumb is to aim to keep your balance below 30% of your limit on each card.

If you're concerned that a recently frozen home-equity line of credit will tip the utilization scales, don't worry. Ethan Dornhelm, of Fair Isaac, the company that compiles the FICO score, says the scoring model excludes HELOCs from such calculations.

So directly from FICO a frozen HELOC will have no impact on your credit score - since its not part of the model. One piece of good news for all of us who have received the shut-off notice...

Living on Debt

People's lives are intertwined with their credit and credit scores. We are accustomed to living beyond our means. The best of us keep reserve that for our mortgages, the worst of us go well beyond. And the downturn has not changed patriotic consumption, rather it has just increased our debt. This article from the Christian Science Monitor titled The 'Catch 22' of consumer credit discusses the issues. Lets take a look -

Renting an apartment, securing a home mortgage, seeking employment, buying a car, even turning on utilities – each of these life experiences will demand a review of your credit history. Nearly 1 in 3 purchases in the United States is made with plastic, or $40 out of every $100, adding to nearly $1 trillion of credit-card debt as of August, according to the Federal Reserve.

Faced with an extended economic recession and a tumultuous global credit meltdown, Americans are finally recognizing the negative consequences of leverage (the number of dollars borrowed for each dollar of wealth). Many people are making a concerted effort to de-leverage by reducing their use of credit cards and adopting a "pay as you go" philosophy. Abstinence from credit cards has become chic among some younger consumers who have formed Web-based networks to support their pledges of credit-card withdrawal.

Some older borrowers are placing themselves on cash-restricted budgets to reduce their urge to buy. A poll of 1,000 Americans released last week by Consumer Action reported that 69 percent of consumers intend to pay with cash and do not expect to take on additional debt in the next 12 months. Only 1 in 4 had opened new credit-card accounts in the past year.

But Americans' commitment to curb credit-card use has ironically become a Catch-22 scenario: By weaning themselves from credit cards, they actually harm their credit reputation.

Whenever consumers lock up or gleefully cut up their plastic, their credit scores drop as they have increased their credit-utilization ratio. This ratio is determined by dividing a person's total of outstanding debt by their total available credit. As borrowers' credit lines are closed, either by themselves or by creditors, their utilization ratio increases and their credit score decreases, hence the Catch-22.

The system is to rely on debt and credit. If you do not have debt you are not shown to be a good consumer. In order to make a huge purchase as a house you need to show that you have lived with credit (debt) for years and that you consistently pay it. If you do not have the proper debt you have a lower FICO score. A lower FICO score can result in a higher interest rate. SO the system is designed to penalize those that do not want to live beyond their means.

Seems like a very unsustainable system for the consumers, however quite beneficial to the lender. Guess it is obvious as to who designed the system.

Trust In FICO

One funny thing I have noticed is that all these well paid executives never imagined that anyone with a decent FICO score would consider walking away. In article after article industry experts and risk analysts are stunned people are doing what is best for them and their families for the immediate future - even if that might mean a hit to their credit and FICO score. My prediction is that as the numbers skyrocket bad FICOs for middle and upper incomes will become less and less of an issue. It will be what a tattoo was in the 1970s. Once just for those on the fringes, now it is they are sported by the nurses in my doctors office.

So today there is an article in the International Herald Tribune about problems arising when homeowners (should really say homedebtors) walk away.

... Rapid declines in home prices in many parts of the United States will soon leave as many as one in five borrowers owing more on their loan than the house will sell for, removing the single most powerful incentive to keep up with payments.

The phenomenon of "walkaways" or "jingle mail," so called because of the noise the house keys make in the envelope mailed to the bank, is hard to measure but shows every sign of gathering pace and having a substantial impact.

One in five borrowers under water. It is said that only about 2/3 of homeowners have a mortgage - so taking that into account then approximately 13% of all properties will be owe more than their house is worth. I wonder if the models ever took that into account...

Wachovia went so far as to change its models on how quickly loans will go bad in the face of what it called "unprecedented" changes in consumer behavior.

"I don't know where the tipping point is," said Don Truslow, chief risk officer at Wachovia. "But somewhere when a borrower crosses the 100 percent loan to value, their propensity to just default and stop paying their mortgage rises dramatically and really accelerates up."

If you are underwater AKA upside, one has to figure out how long it would take them to break even. As the property values spiral downwards people are even more underwater. The analysts need to look at various underwater points - 1%, 5%, 10%, 25%, and 50% underwater. I can not see anyone that underwater staying put - unless renting in the area is more expensive which does not seem to be anywhere. Since people have been encouraged to view their homes as a long-term investment and retirement fund it makes sense for people to walk away. The housing paradigm has changed drastically the last ten years - if a lender paid someone to take a house - with the did with some of these 100% with cash-outs what incentive is their to stay. If your home is worth 50% less than what you owe your credit score will rebound faster than your home value will. So what have the models based on...

He added, "It's almost regardless of how they scored, say, on FICO or other kinds of credit characteristics."

FICO, a credit score developed by Fair Isaac Corp., is one of many barometers of creditworthiness used in home lending to help predict the likelihood that a borrower will repay.

Oh, of course they placed all their trusted in the FICO score. Why would someone want to hurt their credit score - self preservation is stronger than caring about ones FICO score. Modelers used the FICO score to predict future behavior but how many ran those models on properties that lost 30-40 even 50% of their original purchase price or peak value.

... Mark Zandi of Moody's Economy.com estimates that 10.6 million homeowners will have zero or negative equity by the end of June, or 21 percent of first-mortgage holders.

The impact of a new wave of defaults will also be potentially important. Banks and other investors in mortgages, as has been seen, will take further hits to their already weakened capital.

This is just for June, the longer and deeper the recession gets the larger and larger these numbers will become.

While few might shed tears for banks, this means a longer and deeper credit crunch. It will also mean a wave of new properties hitting the real estate market, driving prices lower still, as banks seize and seek to sell the houses homeowners have fled.

Why would anyone worry about the banks - when an investment bank was given a sweetheart deal on a Sunday afternoon. While any help to the individual homeowner drags on and on and includes subsidies for big business. Everyday it seems the Federal Reserve Board is coming up with new ways to help the banks (see here and here) - other than scolding the home-owners not to walk-away what has been done for the little guy? What will be done? And when?

... While borrowers acting in their own best interests really should not shock anyone, the costs associated will be just another unwelcome drag on the economy and finance until the value of U.S. houses stops falling.

The models should be recalibrated using what would be in the homeowner's best interest rather than than relying and focusing on the FICO score. Stories abound of people having problems getting in touch with the current owners of their mortgages, top that off with the lenders rejecting short sales or making them so difficult that people who are trying to do the right thing are not able to - and there are not many choices left. People with great credit and equity are upset about losing their HELOCs. Imagine how furious the people who played by the rules (at the time even if they were too loose) only to find out they are underwater and its getting worse everyday.