New Predictive Analytics for Measuring Consumer Capacity for Incremental Credit

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1 white paper New Predictive Analytics for Measuring Consumer Capacity for Incremental Credit July 29»» Executive Summary More clearly understanding a consumer s capacity to safely take on the incremental debt they are seeking is a challenge all lenders face every day when reviewing credit applications and managing existing customers. This is especially true in mortgage lending, where past approval practices placed many consumers into loan terms that they simply could not afford to sustain, driving the higher loss rates currently being experienced. Traditionally, lending practices include the use of income-based measures, such as debt-to-income ratios, to gauge a consumer s ability to handle incremental debt. Income information itself, however, has limitations in reflecting consumer capacity. Questions include the accuracy of the income field, the predictive implications of gross income relative to disposable income, and other sources of variation such as region and cost of living. What s missing in today s lending practice is the ability to answer effectively, with or without access to income information, Who can safely manage additional debt? While important to all types of lending, this question is particularly critical in both mortgage origination and servicing decisions such as refinance and loan modification. The FICO Credit Capacity Index (CCI), based on a patent-pending technology, represents an anticipatory risk measure that rank-orders consumers based on their ability to manage new or increased debt safely on top of their existing debt loads. In this paper, we discuss FICO s approach to measuring consumer capacity, share studies on recent mortgage loans and present ideas on how mortgage lenders and servicers can benefit from incorporating capacity measures into their portfolio loss mitigation and growth strategies. Make every decision count TM

2 »» Overview Understanding a consumer s ability to take on incremental debt has become increasingly important in today s lending market. Lenders are striving to address over-indebtedness and rising delinquency levels. Lenders who manage this dynamic successfully will improve profitability and help consumers gain access to credit they can manage. Historically, lenders have relied primarily upon consumer credit risk measures and debt-to-income ratios as a means of regulating how much additional credit they believed a consumer could handle. FICO Scores are designed to rank-order future risk based on past behavior, but are not designed to foresee changes in a consumer s credit picture that could have incremental implications for that consumer s overall risk. On margin to risk scores, income measures and measures based on income such as debt-to-income ratio (DTI) are used extensively as a proxy for capacity to drive decisions around mortgage loan approval, in combination with risk scores. Traditional sources of income data, while often verified during application, are rarely updated, making it a less reliable measure for mortgage servicing decisions. Even when income is verified, it does not account for discretionary income relative to cost of living. For example, the same income won t stretch as far for someone living in San Francisco compared to Little Rock. Moreover, one s lifestyle is a strong determinant in disposable income: holding income constant, consumers who eat at restaurants every night can afford less incremental debt than consumers who routinely eat soup. While income-based measures augment lender strategies, stronger measures of capacity would provide a more complete picture of consumer credit risk. With risk scores to measure risk and an appraisal process to measure collateral, a capacity measure along with income will provide a more detailed measure of the three C s of mortgage decision making: Credit, Collateral and Capacity. FICO s pioneering research and validations in the US (and internationally) have demonstrated that credit bureau information can be successfully used to generate an anticipatory risk measure that identifies consumers who are most likely to manage additional credit safely. Moreover, credit bureau information is verified, mitigating concerns regarding consumer reported capacity, and readily available for incorporation into automated underwriting and servicing decision systems. The FICO CCI is now available to help lenders make more profitable and safer lending decisions. Optimized to be used in conjunction with FICO Scores and other underwriting and servicing dimensions, FICO CCI can enable lenders to better target prospects who can more safely take on incremental debt and to more optimally set initial credit product terms, as well as refine existing loan terms and refinance existing mortgages into appropriate new loan terms.»» Measuring Capacity The FICO Credit Capacity Index The FICO CCI was developed using advanced FICO technology to rank-order future risk based on indebtedness actions not yet taken. It has proven to be effective for new credit, such as a new credit card or loan, as well as for increased indebtedness on existing accounts, such as a credit increase on an existing card and a higher mortgage payment as result of an ARM reset or a refinance. Our research demonstrates that, when holding risk constant, consumers identified with a lower capacity for taking on future additional debt are more likely to default with new or increased credit obligations compared to consumers identified as having a higher capacity for incremental debt. Moreover, low capacity individuals identified by FICO CCI can handle relatively small increases in incremental debt, but become significantly riskier following relatively large increases in incremental debt. Identified high-capacity individuals can handle substantially more incremental debt with less change in their overall riskiness. In sum, FICO CCI further segments consumers with similar FICO 211 Fair Isaac Corporation. All rights reserved. page 2

3 Figure 1: Theoretical Consumer Capacity Concept At a Given Risk Score BAD RATE ( % ) Scores based on their ability to manage incremental debt safely, thereby providing lenders with a more comprehensive view of the consumer s future performance on the credit product offering. Figure 1 illustrates the notion that some consumers have greater capacity for additional debt than others, with each line representing a consumer with a different capacity to handle incremental debt. The theoretical consumers on this chart have similar FICO Scores at time of scoring with the same default probability of 2%, given no change to their indebtedness in the future (the far left on the graph). However, while these consumers have Figure 2: FICO CCI Validation Results Demonstrating FICO CCI Rank Orders within a FICO Score Band for Increased Installment Loan Payment MORTGAGE BAD RATE ( % ) Harry Low Capacity Mary Mid Capacity Larry High Capacity INCREMENTAL DEBT ( $ ) Consumers have at least one open mortgage as of Oct 6 Bad definition (9 days delinquent or worse on mortgages between Oct 6 and Oct 8) CCI CCI 5 CCI 1 CCI FICO Score CCI 2 CCI 7 CCI 3 CCI 8 CCI 4 CCI 9 INCREMENTAL INSTALLMENT LOAN PAYMENTS (BETWEEN OCT 6 AND OCT 7) ( $ ) similar default probability when all else is held equal, they have different capacity to handle additional debt taken on over time, which affects their future risk, as illustrated by three curves of the increasing bad rates (the y-axis) as balances increase (along the x-axis). Note that everyone has a point at which excessive debt results in default. Thus, it is important to remember that using a capacity measure to render credit extension decisions will not preclude even the highest-capacity consumers from default if pushed too far. This theoretical concept has been replicated on independent validation data to show that FICO CCI, used in conjunction with a FICO Score, is able to separate these differing profiles with respect to capacity. FICO CCI is a rank-ordering tool with which higher scores indicate higher capacity when associated with incremental debt defined as lower expected risk (9 days delinquent or worse) over 24 months after the scoring date. Figure 2 is a part of a recent validation that illustrates how the FICO CCI is able to distinguish consumers who can safely take on incremental installment debt compared to those who cannot in a given FICO Score range. The population shown represents a group of mortgage accounts pooled across multiple lenders. The graph shows consumers with a similar risk profile (FICO Score in the range) and who all have at least one mortgage open as of October 26 (FICO score and FICO CCI score generated/appended to sample). Along the x-axis, we listed the Incremental Installment Loan Payments (including mortgages) that these consumers experienced between October 6 and October 7. The increase in installment loan payments reflect new 211 Fair Isaac Corporation. All rights reserved. page 3

4 Figure 3: FICO CCI Validation Results Demonstrating CCI Rank Orders within Each of Four FICO Bands for Increased Total Installment Loan Payment Mortgage Bad Rate ( % ) Mortgage Bad Rate ( % ) Consumers have at least one open mortgage as of Oct 6 Bad definition (9 days delinquent or worse on mortgages between Oct 6 and Oct 8) CCI 3 CCI 4 6 CCI CCI 3 CCI 4-6 CCI 7 8 CCI FICO Score FICO Score installment loan(s) opened, an increase in monthly payments on existing installment loan accounts, or both. The y-axis indicates the consumers performance on mortgage loans over 24 months after the scoring date. Note the range of results at different levels of FICO CCI. Those who were low capacity (yellow, blue and green lines at the top of the graph) become much more risky as a function of incremental debt, while those with higher capacity levels (purple, pink and red lines at the bottom of the graph) were less affected by the incremental debt. Similar results (see Figure 3) were found for various FICO score ranges such that, when used in conjunction with the FICO score, FICO CCI successfully distinguishes between those who safely managed their incremental installment loan debt and those who did not. Mortgage Bad Rate ( % ) Mortgage Bad Rate ( % ) CCI 3 CCI 4-6 CCI 7 8 CCI FICO Score CCI 3 CCI 4-6 CCI 7 8 CCI FICO Score INCREMENTAL INSTALLMENT LOAN PAYMENTS (BETWEEN OCT 6 AND OCT 7) ( $ ) 211 Fair Isaac Corporation. All rights reserved. page 4

5 »» Using the FICO Credit Capacity Index in Mortgage Lending Decisions Taking this concept to an implementation level, how would a mortgage lender or servicer make use of the FICO CCI in their risk management and credit extension decisions? In general, when considering how to employ the FICO CCI, lenders should use this new risk measure in conjunction with existing decision criteria such as FICO Scores, verified income and other applicant data, and loan term information. The FICO CCI can serve as a key part of a holistic mortgage lending strategy to answer the question, How likely is this consumer to handle this loan amount safely in addition to their existing debt load? CCI can add value within both mortgage servicing and mortgage origination decision areas. Origination Decisions In mortgage originations, the FICO CCI can be incorporated into existing underwriting strategies, providing new insight into the applicant s credit capacity not otherwise captured. The FICO CCI can be used to help determine initial loan pre-qualification, approve/decline decision, appropriate loan amount, required down payment and risk-based interest rate offering. An example of a FICO CCI use case in originations is illustrated in Figure 4. For ease of reading, we have kept the sample strategy below somewhat basic, to demonstrate how a mortgage lender could leverage the FICO CCI within an origination s strategy. Consumers with very low FICO Scores and high DTIs who would not put down substantial down payments (resulting in high LTVs) would continue to be declined (same as current strategy). Consumers with very high FICO Scores, low DTIs and sizable down payments would continue to be courted with competitive rates. However, the remaining areas would be evaluated to further differentiate treatment based on the FICO CCI. Segments with low CCI scores, higher down payments should be requested to lower the monthly mortgage debt burden. Segments with high CCI scores, lower down payments with higher payment amounts can be considered. 211 Fair Isaac Corporation. All rights reserved. page 5

6 Figure 4: Using FICO CCI in Practice Simplified New Mortgage Origination Strategy Low Moderate High Very Low Decline Low Moderate Request Higher Down Payment Standard Origination Procedure Request Lower Down Payment High Very High Accept with Competitive Rate FICO CREDIT CAPACITY INDEX TM Servicing Decisions Given current challenges with the declining value of mortgage portfolios, many mortgage entities have shifted focus to loss mitigation efforts on existing mortgages. Foreclosure prevention has become a top goal of lenders and government-initiated mortgage recovery activities. The FICO CCI can be used in proactive loss mitigation efforts by helping to predict consumers at greater risk of mortgage default and potential foreclosure effectively due to an increase in debt burden (i.e., an increase in mortgage monthly payment). Leveraging this analytic will help servicers target potential delinquencies and begin the loss mitigation process earlier to increase strategy efficacy and yield. A segmentation tree using the FICO Mortgage Score 1 and the FICO CCI for targeting mortgage default is illustrated in Figure 5. The segmentation scheme can be used in conjunction with the Home Affordability and Stability Plan (HASP) rules to further segment the mortgage loans by differing probabilities of default risk. The example shows that among all current loans not addressed by HASP (DTI < 31%, LTV > 5%, conforming), a small fraction of the segment captured by low FICO CCI and low FICO Mortgage Score is extremely risky. With no loss mitigation actions taken, the default rate is over 16% in this segment when measured over a six-month period. Compare that to the 6% default rate observed in the medium risk segment and the 1% default rate in the low risk segment measured over the same six-month period. Using CCI in conjunction with FICO Mortgage Score in a simplified segmentation tree, a servicer could more accurately identify higher risk loans from each segment of their servicing population to take immediate action before it is too late to prevent foreclosure. Lenders can use this approach to prioritize limited resources and time by directing the highest risk segments to the loss mitigation department while directing the rest less risky accounts to customer service centers for more traditional refinance options The FICO Mortgage Score is a new score specifically designed to help mortgage lenders make the best possible risk decisions when addressing both current mortgage holders and those aspiring to own a home. By leveraging the power of the base FICO Score, which was developed and tuned to all trades in a consumer s credit file, the FICO Mortgage Score is specifically fine tuned for the mortgage industry by focusing on those mortgage-related trades. This new score offers predictive improvements for mortgage risk of as much as 25% in certain population segments compared to the base FICO. 211 Fair Isaac Corporation. All rights reserved. page 6

7 Figure 5: Targeting Imminent Mortgage Default a simplified segmentation scheme using the FICO Mortgage Score and FICO CCI Rules for Segment 1: Not HASP eligible Current, first-lien, conforming, LTV > 5, front-end DTI < 31% Segment 1 Not HASP Eligible High Risk Segment Segmentation Rule: MIO Low or CCI Low Medium Risk Segment Segmentation Rule: MIO Medium or MIO Low and CCI Medium Low Risk Segment Segmentation Rule: MIO High or MIO Medium and CCI High Bad Rate: 16% Average $ Bad: $47,245 Bad Rate: 6% Average $ Bad: $18,951 Bad Rate: 1% Average $ Bad: $3,172 The FICO CCI can also be used in mortgage refinance decisions to assist lenders in determining appropriate new loan terms. A strategy using FICO CCI in conjunction with other existing inputs in refinance decisions can be developed in such a way that is similar to the strategy shown in Figure 4 for origination decisions.»» Value of the FICO Credit Capacity Index in Mortgage Lending More Control Over Loss Exposure and Reserves: Using the FICO CCI in conjunction with existing mortgage lending strategies allows lenders to refine loan origination policies to reallocate loss exposure toward those consumers best able to repay debt and limit exposure when consumers pose a higher risk of default. Such reallocation or reduction in exposure might allow lenders to reduce their loss reserves and reallocate working capital to more profitable areas of business. Improve Portfolio Profitability: When used in conjunction with existing strategies, the Credit Capacity Index should allow lenders to better avoid loss exposure on new mortgage accounts. It should also enable them to mitigate losses on existing customers by offering better informed loan modification or refinance terms that correspond to the amount that the customer can safely handle. Demonstrate Responsible Lending Practice: Proactive management of consumer debt loads would help address consumer groups and legislative pressures regarding agreed, standardized, documented work practices specifically aimed at reducing or better managing consumer over-indebtedness. 211 Fair Isaac Corporation. All rights reserved. page 7

8 »» Summary Today s lending challenges call for a new approach to address consumers capacity to handle new and existing mortgage loans. The Credit Capacity Index, now available from FICO, is based on a patentpending technology, which unlike traditional bureau-based risk modeling, can isolate consumer sensitivity to new debt not currently present on the credit report and infer a consumer s capability to handle incremental future debt. FICO research reinforces the added predictive value of the Credit Capacity Index when used with FICO Scores. Validation results for both new and existing mortgage accounts show that the Credit Capacity Index effectively rank-orders consumers most likely to be affected by incremental debt within each FICO Score range those who, without a change in debt, would have a similar expected risk of default. The Credit Capacity Index, like the FICO score, is an objective risk measure designed to comply with the Fair Credit Reporting Act (FCRA) and meet the consumer and legislative fairness test. Based solely on credit repayment history, it is recommended to be applied equally across all consumer segments and is fully compliant with the FCRA. The FICO Credit Capacity Index offers mortgage lenders a major advantage by adding a new dimension to risk assessment for a more complete picture of consumer creditworthiness. 211 Fair Isaac Corporation. All rights reserved. page 8

9 about FICO FICO (NYSE:FICO) delivers superior predictive analytics solutions that drive smarter decisions. The company s groundbreaking use of mathematics to predict consumer behavior has transformed entire industries and revolutionized the way risk is managed and products are marketed. FICO s innovative solutions include the FICO Score the standard measure of consumer credit risk in the United States along with industry-leading solutions for managing credit accounts, identifying and minimizing the impact of fraud, and customizing consumer offers with pinpoint accuracy. Most of the world s top banks, as well as leading insurers, retailers, pharmaceutical companies and government agencies, rely on FICO solutions to accelerate growth, control risk, boost profits and meet regulatory and competitive demands. FICO also helps millions of individuals manage their personal credit health through Learn more at FICO: Make every decision count. FICO, Credit Capacity Index and Make every decision count are trademarks or registered trademarks of Fair Isaac Corporation, in the United States and in other countries. Other product and company names herein may be trademarks of their respective owners Fair Isaac Corporation. All rights reserved. 2581WP 4/11 PDF For more information US toll-free International web () [email protected]