Credit Scoring Education

From a mortgage lenders point of view, a good credit score translates into lower interest rates for mortgage borrowers. The higher your score is, the lower risk you are, and more likely it is you will pay this debt in a timely manor. For this reason borrowers with lower scores usually pay a higher interest rate on their loans.

If this is you, don’t panic. Most loan officers are trained to deal with these situations everyday. I would like to give you a few guidelines on what you can do to adjust your score and receive a favorable review from lenders underwriters.

Also read the article on how to raise your score. But first take a moment to educate yourself on the scoring model, or FICO score. Loosely defined, a credit score is simply a snapshot of a person’s credit at a given time.

WHAT IS A GOOD CREDIT SCORE?

Let’s review briefly the difference between a great credit score and a mediocre credit score. First of all, the highest credit score any of us can receive is 850. Anything over 720 is outstanding.

Let’s talk about interest rates for a moment. If you have a 721 credit score vs. a 718 credit score, it could mean the difference between you qualifying for an interest-only loan on your jumbo mortgage versus not qualifying at all. It can have that big of a difference. We’ll talk in depth in a moment about how to possibly monkey with the credit-scoring model once you understand it. This may enable you to increase the score above 720 so you can take advantage of some of the best programs in the business. The bottom line is that 720 is that first magical number. Anything above that gets you the best interest rates; if you are below that, you might be paying some penalties.

The next significant tier is 680. Between 680 and 720, you’ll still get a very attractive interest rate, and you will probably have access to all of the different programs in the marketplace. However, there may be some restrictions, especially if you need to go with a stated income type of loan. In other words, if you have above a 720 credit score, you don’t have to provide tax returns to prove income. If you are between 680 and 720, you may be required to provide this information. Stated income means a type of loan for which you don’t need to prove your income.

The next tier down is 620. If you drop below 620 on your credit score, you are deemed a "less than A paper" borrower. This means you typically will have an inferior interest rate or additional costs because your score is lower than 620. Let’s address what comprises a credit score, so you can understand how the formula breaks down and how to improve your score.

PAYMENT HISTORY

35% of the score is based upon payment history. The more recent and derogatory the late payment, the more negative effect it has on the score. Missing low payments is better than missing high payments. So, if you missed a $40 per month payment, it won’t have as negative an effect as if you missed your car payment of $650.

ACCOUNT BALANCES

Comprising 30% of the credit score is the account balances. This is a tricky area, if you understand it; you can significantly tweak your credit score. Ideally, you want to keep your balances below 10% of the available credit limit. Therefore, you are better off spreading your balance over a few cards than having it all on one card. If you go over 30% of the available credit, you’ve crossed that next threshold, and you’ve diminished your score. Once you go above 50%, your score diminishes even further, and then you are really in trouble if you go above 70%. That’s when you begin to be heavily penalized on your score, and people drop down into the high 500’s or low 600’s.

LENGTH OF CREDIT HISTORY

Comprising 15% of the credit score is the length of credit history. This means you want to hold on to old credit cards, even if the rate is not good. You are rewarded for having long-term credit card debt. Just keep in mind that 30% is account balances.

TYPE OF CREDIT

Comprising 10% of the score is the type of credit. A good mix is always best—an auto loan, a mortgage payment, a few credit cards, etc. Three to five revolving credit accounts (credit cards or lines of credit) is the optimal number that the score really rewards. Anything less than that means you haven’t established enough credit. Anything more than that and you’ll be penalized because there will be concern that you are a heavy credit user.

A mortgage will raise your score, once you’ve made the next payment. New credit temporarily drops your score until it leaves the unrated status position. If you go out a get a new credit card, until the first payment is made and the account registers in paid status, the account will be unrated. So, for the first 45 days or so, before you make your first payment, your score will be penalized. After that first payment is made, however, your score will begin to go up.

INQUIRIES

The final category, which also represents 10% of your score, is inquiries. Multiple mortgage and auto inquiries are treated as one as long as they are within a 14-day period of time. In other words, if you go to four different auto lots and three different mortgage brokers in one day, and they all run your credit, this will only be treated as one inquiry per type. If you shop over an extended period of time, that will bring your score down.

Inquiries will affect your score for up to one full year. They don’t drop off until a year after you have your credit inquired upon. Your score is only reduced for the first ten inquiries. In other words, if you go out and rack up nine or ten inquiries, you will see some significant reduction in your score, even though it only represents 10% of the model. It can be anywhere between 2 and 50 points, depending upon the other variables involved.