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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.

Credit Risk, Credit Scoring, and the Performance of Home Mortgages