What is a credit score?
Imagine that a friend asks to borrow money from you. Assuming you had the money to loan, you might then ask yourself, “Did he pay me back the last time he borrowed money? Did he pay me back the full amount? On time?” When you approach banks and lenders for a loan, they go through a similar analysis, but since they don’t know you personally, they use your credit history to determine whether you will be a responsible borrower. Lenders learn about your credit history by looking at your credit report. You can get a free Credit Report Card that includes your free credit score right now!
Credit reports are developed by three separate credit agencies. These agencies (Equifax, Experian, and TransUnion) gather information about your credit history, and, using a formula developed by Fair Isaac Corporation (FICO), each assigns you a credit score. You will end up with three slightly different credit scores, each from one of the three agencies. Lenders typically look at your middle credit score (as opposed to the highest or the lowest), and you must provide all three of your credit scores (one from Equifax, one from Experian, and one from TransUnion), when applying for a loan.
Why are credit scores so important when buying a home?
Your credit score helps determine the rate and conditions you receive on a loan. If your credit score is high, meaning that your credit history indicates that you’ve paid your credit card bills on time, haven’t “maxed out” your credit cards, etc., then lenders believe it’s a fairly good bet that you won’t have difficulty paying off your loan. They will see you as a low-risk investment and offer you a low rate on your loan with good conditions.
If your score is lower, lenders will think you’re a riskier investment, and charge you (by loaning you money at a higher interest rate, often including hidden charges) to take on the perceived risk. Get your free credit score now.
How do credit scores affect you when applying for a loan?
Most lenders have a baseline credit score by which they largely make their decision to approve or deny mortgage applicants. The maximum credit score is 850 (though a score of 850 is rare, indeed. Only about 10% of applicants have a score over 800). Any score in the 700s or above is excellent and will get you a loan with the lowest interest rate. When you get into the 600s it starts getting dicey. A score of 680, for example, is still considered good, but when you get below 660, some lenders start saying, “No.”
For others, 640 or 620 is the line at which you won’t be considered for their better programs. Once you get into the 500s, you are a candidate only for what the industry calls subprime loans, those with interest rates that are a couple of percentage points higher than those offered to prime borrowers. Subprime loans also often come with a lot of hidden charges.
So you can see the importance of keeping a good score. It used to be okay to miss a credit card payment deadline. You might pay a $15 late fee. Big deal! But if you do this on a regular basis, it can savage your score and cost you many, many times that amount when you want to buy or refinance a home. That’s the bad news.
The good news: your credit score isn’t fixed in stone. If you have bad credit scores, there are ways to improve your credit health. If you find your scores are lower than you expected, you’ll need to engage in credit rehab. This is different from credit repair, defined as going to an outside company that promises to cure your problems and raise your scores. There may be some good ones out there (along with some disreputable ones) but they can’t do anything you can’t do yourself and you shouldn’t waste your time or money going to them for help.
From a financial standpoint, it is almost always better to take the time to improve your credit health, and make yourself eligible for a better interest rate, than it is to apply for a loan with a credit score that will only make you eligible for a subprime loan.
Some Great Tips on Improving Your Credit Score
There are 5 main parts of your credit score.
(1) Payment History : 35% of your credit score
Payment history measures how you’ve paid on your debts. Payment history is the largest part of your credit score because if you’ve recently missed payments your creditors, it’s likely those missed payments will continue, and may lead to default. Payment history also measures how “severe” a missed payment has been. An item in collection is worse than an item paid 30 days late.
Tips to improve : Make payments on time, all the time — even items in dispute. Pay the bill and worry about refunds later.
(2) Amounts Owed : 30% of your credit score
Amounts owed measures how “maxed out” you are. Amounts owed is the second-largest part of your credit score because a person that is maxed out has no safety valve in the event of a crisis. Amounts owed is not about the dollar amount you’re borrowing — it’s about the dollar amount you’re borrowing relative to the amount available to you.
Tips to improve : Don’t close out “old” credit cards, and don’t lower your available credit limits. Having access to credit is good.
(3) Credit History Length: 15% of your credit score
Your credit history is your track record with respect to managing credit. Credit history matters in the FICO model because “experienced users of credit” are viewed differently from new users of credit. Similar to the hiring process for a job, the credit bureaus want to see this isn’t your first experience.
Tips to improve : Don’t close cards with “history”. You need them to show you’re experienced with credit.
(4) New Credit : 10% of your credit score
This category accounts for your recent attempts to secure new credit. In general, the more credit for which you’ve applied, the more damage it will do to your credit score. This is more true for credit cards than for mortgage applications. A consumer in search of new credit cards is presumed to “need” more credit lines.
Tips to improve : When you shop for a mortgage, multiple credit checks can count as a single credit inquiry, protecting your credit score.
(5) Types of Credit : 10% of your credit score
The type of credit you carry matters and not all credit types are the same. Installment loans such as mortgage loans and student loans, for example, are considered “better” than credit cards and charge cards. This is because installments loans eventually pay down to zero. Consumer cards, by contrast, can only go up.
Tips to improve : Don’t carry an abundance of store charge cards. Interest rates are high and the FICO model looks unfavorably upon them.
- Keep Clear Of Credit Limits – Carrying a $500 balance on a $500-limitcredit card is bad for your FICO. You’re“maxed out”. Carrying $500 on a $5,000-limit credit card, however, is good for FICO.You’re far from your limit. Keep balance ratios under 30% for best results.
- Resist “Cash Register” Offers – Many retail stores offer discounts for“opening up a store charge card”. Thediscounts are tempting, ranging up to 25%of your purchase price. To receive yourdiscount, however, you’ll be subject to a credit inquiry for a charge card that will be nearly maxed-out from the outset. These are each negative forces on your FICO. If you’rebuying a home sometime soon, you maysave more money by passing on the in- store offer.
Find Out Where You Stand
You can check your credit score each month using Credit.com’s free Credit Report Card. This completely free tool will break down your credit score into sections and give you a grade for each. You’ll see, for example, how your payment history, debt and other factors affect your score, and you’ll get recommendations for steps you may want to consider to address problems. In addition, you’ll also find credit offers from lenders who may be willing to offer you credit. Checking your own credit reports and scores does not affect your credit score in any way.
Thanks for reading!