Home buyers who are seeking a mortgage find out early-on that their credit score plays an important part in the home buying process and in determining the interest rate that a lender offers.
What is a credit score?
A credit score is a number that lenders use to estimate risk. Experience has shown them that borrowers with higher credit scores are less likely to default on a loan.
How are credit scores calculated?
Credit scores are generated by plugging the data from your credit report into software that analyzes it and cranks out a number. The three major credit reporting agencies (Equifax, TransUnion and Experian) don't necessarily use the same scoring software, so don't be surprised if you discover that the credit scores they generate for you are different.
To make the most of your credit, you need to know exactly how your credit score is calculated. There are five components to your score and some carry more weight than others.
Why are credit scores sometimes called FICO scores?
The software used to calculate a great number of credit scores was created by Fair Isaac Corporation--FICO.
Which parts of a credit history are most important?
In 2009, changes were made to the way credit scores are calculated. Below is an outline of the five major components to your credit score, and the changes that have been made.
1. Payment History - In the past this has been the largest factor in your credit score. It includes:
- Number of accounts paid as agreed
- Negative public records or collections
- Delinquent accounts:
- total number of past due items
- how long you've been past due
- how long it's been since you had a past due payment
Prior to 2009, 35% of your credit score was based on your payment history. Paying on time can still mean the difference between average and exceptional credit, but now one slip up won't hurt as much. If you have a history of paying on time across most of your accounts, but have an occasional mess up and pay late, this won’t affect your credit score as much as it used to.
Since this category has such a big impact on your overall credit score, when you go through a foreclosure (or short sale) it is not just the foreclosure that impacts your credit, but also the months of late payments that precede the foreclosure.
2. Amount Borrowed Compared to Available Credit - Now a Bigger Factor in Your Credit Score:
Historically, the amount of revolving debt you own in relation to your available credit balances has accounted for 30% of your credit score. It is calculated on an individual account basis and an overall basis.
Although we don’t know the exact weighting of this factor, in 2009, your overall debt will play a bigger role in your credit score than it has in the past. It may now have a bigger affect on your credit score than your payment history.
What can you do? Make sure you don’t borrow more than 50% of your available balance from any single lender, and ideally you want to borrow less than 33% of your available balances. This means contrary to popular belief, it is better to owe a smaller amount on several cards than to max one card to its limit.
Following are things credit scoring agencies look at when calculating this component of your score include:
- How much you owe on accounts and the types of accounts with balances
- How much of your revolving credit lines you've used--looking for indications you are over-extended
- Amounts you owe on installment loan accounts vs. their original balances--to make sure you are you paying them down consistently
- Number of zero balance accounts
3. Length of Credit History - Raise Your Score by Keeping Accounts Open Over 7 Years
Your length of credit history comprises about 15% of your score. People with credit scores over 800 typically hold at least three credit cards (with low balances) which they have had open for over seven years each. Rather than closing accounts it is best to work toward paying them off, and then let the accounts remain open with a a small amount of activity that is paid off each month. Other things in determining the calculation include:
- Total length of time tracked by your credit report
- Length of time since accounts were opened
- Time that's passed since the last activity
- The longer your (good) history, the better your scores
4. Types of Credit - Installment Debt More Favorable to Your Credit Score than Credit Card Debt
10% of your score is based on the type of credit; installment vs. revolving debt. Installment debt, such as an auto loan, is looked upon more favorably than revolving (credit card) debt. In addition, with the 2009 changes, you now get points for your ability to successfully manage multiple types of debt; a mortgage, auto loan and credit cards, for example. So keep in mind:
- Total number of accounts and types of accounts (installment, revolving, mortgage, etc.)
- A mixture of account types usually generates better scores than reports with only numerous revolving accounts (credit cards)
5. Inquiries and New Debt -These Lower Your Credit Score
Inquiries and new debt account for about 10% of your score. The good news; if you are shopping for a house, all mortgage inquiries within thirty days of each other will be grouped as one inquiry. For autos, it is a fourteen day limit. In 2009, inquiries for new debt will have less of an effect than they used to. Items included in this calculation include:
- Number of accounts you've recently opened and the proportion of new accounts to total accounts
- Number of recent credit inquiries
- The time that's passed since recent inquiries or newly-opened accounts
- If you've re-established a positive credit history after encountering payment problems
- In general, checking to make sure you aren't attempting to open numerous new accounts
Credit scoring software only considers items on your credit report. Lenders typically look at other factors that aren't included in the report, such as income, employment history and the type of credit you are seeking. It is very important that once you get prequalified for a loan that you do not do anything that will adversely affect your income or your credit score, therefore, until after the closing on your new home, do NOT make any large purchases such as autos or furniture. Even though you have already been preapproved, the lender will normally check your credit score again a day or two prior to the closing and if the score is lower, the lender may not grant the loan!!
What's a Good Credit Score?
Credit scores (usually) range from 340 to 850. The higher your score, the less risk a lender believes you will be. As your score climbs, the interest rate you are offered will probably decline.
In 2009, as a result of the lending crisis, most (but not all) lenders require a minimum credit score of 600 - 620 for a buyer to qualify for a loan.
Borrowers with a credit score over 700 are typically offered more financing options and better interest rates, but don't be discouraged if your scores are lower, because there's a mortgage product for nearly everyone.
Multiple Credit Scores
Your bank will pull credit reports and scores from all three major credit reporting agencies: Transunion, Equifax and Experian. They'll probably use the middle score to work your loan application. Ask your lender to explain which credit scores will be used and how they affect your loan application.
