Credit Scoring Explained
A credit score is a numerical representation of your credit worthiness and a factor that will be considered by the lender when they look at your loan application. They want to know what your credit history is, and whether you have the ability to pay back the loan you are asking for. In short, good credit translates into lower rates for the home buyer and represents less risk to the lender.
The higher the borrower’s credit score is, the less likely they are to default on their loan. All lenders will run a credit report and determine what your credit score is, and if necessary, can point out some simple ways to help you improve your credit score without enlisting the help of a credit repair service.
To improve your credit score, concentrate on paying your bills on time, paying down outstanding balances, and not taking on new debt in the 6 months prior to purchasing a home.
The Five Main Criteria that make up a credit score:
In addition, the credit report provides any bankruptcy, liens, or public records filed. If you have any derogatory credit items (late payments, collections, bankruptcy, foreclosures, repossessions, etc.) you will want to type an explanation letter to the lender for these items. This letter provides the lender with the background on why these derogatory items came about and what you are doing to prevent these issues from arising again. Lenders want to hear that derogatory items on the credit report are isolated events in the past that occurred due to some extenuating circumstances.
Fair, Isaac Credit Bureau Scores (“FICO” Scores) range from a low score of 300 to the highest of 900 and are reported by the following three national credit bureaus. Please note that the results from each bureau can vary:
Credit scores range from 300 to 850 and are commonly broken down into the following categories:
What actions will affect your FICO Credit score?
The following are the top items that will actually lower your FICO score. Avoiding these actions prior to applying for a mortgage loan will help to increase your score.
Missing Payments - no matter the dollar amount, $5 or $500, if you miss a payment it hurts your score the same. And only one late payment takes 2 years to restore credit. Missing a mortgage payment hurts your score worse than missing any other payment.
Credit cards balances at or near the credit limit – the closer your balance is to the credit limit, the more it hurts your score. If your balance is:
< 30% of your credit limit – it will not drop your score.
30% - 49% of your credit limit – takes away 10% of your available credit points
50% - 89% of your credit limit – takes away 25% of your available credit points
90% - 100% of your credit limit – takes away 90-100% of your available credit points
Some credit card companies do not report a credit limit to the credit bureaus in which case the model assumes your current balance is 100% of your available limit, which lowers your FICO score. Two common cards that do not report limits are Amex & Capital One.
Excessive credit inquiries and new accounts - applying for several new accounts/loans within a 12 month period will negatively affect your score, however, multiple mortgage companies that pull your credit report within a 44 day time period will only count as one inquiry. This is the same for the Auto industry too.
Having more revolving credit in relation to installment credit – revolving credit (credit cards, retail store cards, etc) counts against you more than installment credit (mortgage, car loan, student loan, etc)
What does NOT affect your FICO score?
The FICO Credit score models are NOT affected by:
The Five Factors of the Score
- Payment History = 35% impact
- Paying debt on time and in full has a positive impact.
- Late payments, judgments, and charge-offs have a negative impact.
- Missing a high payment has a more severe impact that missing a low payment.
- Outstanding Credit Balances (Amount Owed) = 30% impact
- The ratio marking the difference between the outstanding balance and the available credit is important.
- Ideally, a consumer should keep his/her balances below 10% of the available credit limit.
- Number of balances recently reported
- Average balance across all tradelines
- Credit History (Length of Time) = 15% impact
- This marks the length of time since a particular credit line was established.
- A seasoned borrower is stronger in this area.
- Type of Credit = 10% impact
- A mix of auto loans, credit cards, and mortgages is more positive than a concentration of debt from credit cards and other revolving credit accounts only.
- Number of trade lines reported for each type is part of the analysis
- Inquiries & New Credit = 10% impact
- This quantifies the number of inquiries and new account openings that have been made on a consumer’s credit history within a six-month period. Each hard inquiry can cost from two to 50 points on a credit score.
- The maximum number of inquiries that will reduce the score is 10. Eleven or more inquiries in a six-monthly period will have no further impact on the borrower’s credit score.
- Recent inquiries from a variety of lending institutions (credit card company, commercial bank, mortgage lender, and credit union) will have a greater negative effect than recent inquiries from only one type of lending institution (three mortgage companies).
- The following types of inquiries will affect the credit score:
- Mortgage applications
- Credit card applications
- Auto loan applications
- The following type of inquiries will not affect your credit score:
- Requests for a credit report from a consumer reporting agency
- Lender account review
- “Pre-Approved” credit offers
- Employment or tenant screening
How can you improve your FICO score?
The following is a list of actions that have a big impact towards helping your score. However, it takes careful balance to achieve the goal as some ‘improvement actions’ may hurt your score if not done carefully, contact Julie for Guidance.
- Make ALL payments on time, ESPECIALLY your mortgage & Student Loans!
- Stop applying for any new credit cards and/or loans. Approximately 6-12 inquiries within 90 days will lower your score about 1 point per inquiry. More than 15 inquiries within 90 days will lower your score about 2.5 points for EACH inquiry.
- Pay down credit card balances to 30% or lower of the available limit. If that is not possible, then try to get below 50%. Just make sure your balance is never more than 90% of your available credit limit. You can also ask your credit card company to raise your credit limit to help give you a lower balance ratio. Be careful when doing this, you must not spend any more or you will be in worse shape. Also note that when you ask to have your limit increased, a credit inquiry is performed on your credit report.
- If you have more than 5 revolving accounts, close the newer accounts and keep the older (longer history) accounts. Closing accounts less than 2 years old can help your score, but you should have 2-4 revolving accounts open.
- Take $500 to your bank and open up a 6 month CD. Get a $500 secured loan using the CD as collateral. Immediately pay back $300. Each month, make DOUBLE the minimum payment. After 6 months, you will have good credit to start offsetting the bad credit. Repeat this action more than once to continue to improve your credit
- Make sure your credit card company reports a credit limit. If they won’t, then pay off the balance or transfer the balance to another account that does.
- Try to have 3-5 OPEN and ACTIVE accounts (loans, credit cards, mortgage, etc) in good standing on your credit report. More good credit will help offset any bad credit and most lenders require at least 3 active accounts to give you a loan.
- Review your credit report once a year. You can obtain 1 free credit report a year by contacting www.annualcreditreport.com
Time Limits on credit reports
- Paid as agreed will remain for 10 years
- Not paid as agreed with remain for 7 years
- Remain for 7 years - based on the “Date of Last Activity” on the collection account
- Remain for 7 years from the date filed, except for the following:
- Bankruptcy – Chapter 7 and Chapter 11 will remain for 10 years from the date filed
- Bankruptcy – Chapter 13 “non-dismissed” or “non-discharged” will remain for 10 years form the date filed
- Unpaid tax liens will remain indefinitely
- Paid tax liens will remain for up to 7 years form the date released
Know your credit rights!
The Fair and Accurate Credit Transactions Act, was signed by President Bush on December 4th 2003 and is enforced by the Federal Trade commission.
You may view the Act in its entirety at:
Who keeps all your credit history data?
Toward the end of the 1800's, when the concept of tracking someone's credit was coming into being, one store would simply call another store where the customer had been doing business to see how he or she was as a customer.
As people started moving across the U.S., the need for Consumer Reporting Agencies (CRAs) became apparent and local bureaus starting appearing throughout major cities. Inevitably, three major CRAs emerged - Equifax, TransUnion, and Experian, known as the credit bureaus. These bureaus are the ones who retain your credit history data and calculate your FICO Credit score.
Equifax – www.equifax.com / 1-800-685-1111
TransUnion - www.tuc.com / 1-800-888-4213
Experian - www.experian.com / 1-888-322-5583
By law, you are also entitled to receive ONE free credit report per year. Contact www.annualcreditreport.com and answer the questions to receive your free report.