CHAPTER 6
Credit Scores: What They Are, How They Work, and How to Improve Them
Credit scores, which came into full force in the late 1990s, have changed the way mortgage loan approvals are issued, much the way Automated Underwriting Systems have done. Establishing a credit history is a requirement for obtaining a mortgage, and a credit score is the number assigned to quantify the quality of credit. Understanding how credit scoring and mortgage lending work hand in hand can give you the upper hand when negotiating your loan terms.
6.1 WHAT ARE CREDIT SCORES?
Credit scores are numbers that are derived from a consumer’s credit history. The number reflects the various credit details in a consumer’s past. People with higher credit scores get better rates than those with low credit scores. A score also attempts to determine the likelihood of default on a loan. The higher the score, the less likelihood of missed payments. The lower the score, the greater the credit risk. At least according to the scoring model.
Credit scoring has been around for years; it was just done manually. Give so many “points” for paying loans on time, so much for job stability, more for low debt ratios, and so on. Credit scoring was used mostly for credit cards. Have you seen all those signs in the mall or at a department store advertising “instant” approval for a store account? They use a method of scoring. Your basic information—whether you own a home or rent, your income, where you’ve lived, etc.—is entered into a database and your credit is reviewed by a software program while you wait. A few moments later, voilà! Shop till you drop.
Credit scoring for mortgages is relatively new compared to other consumer lending, like credit cards and installment loans. Credit scoring for mortgages was developed by a company called the FICO Company, or FICO, formally named the Fair Isaac Corporation, hence the FICO acronym. When you hear the term FICO being used generically, such as, “What’s your FICO?” it really means, “What is the credit score that the FICO has calculated for you?” All three credit repositories use the FICO scoring system, but their credit scores are usually different because the three repositories pull information from different parts of the country and collect different information.
Credit scores can be as low as 300 or as high as 850. Personally, I’ve never seen a score higher than 810, and if there is someone out there with an 840, I’d like to meet them. I’m not saying it’s impossible, I’ve just never seen one. People with excellent credit generally have their credit scores at 720 or above. Good credit starts around 680 and average credit is around 660. Scores below that may be considered damaged or impaired credit.
Credit scoring is not an exact science—at least to the general public. How credit scores are calculated is not divulged to the public because credit reporting companies want to keep people from manipulating the scores. The score itself is more of a two-year overview of recent credit behavior.
6.2 WHAT MAKES UP A SCORE?
Numerical values are assigned to your payment patterns, available credit, how long you’ve had credit, the number of credit inquiries, and types of credit.
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Certain payment characteristics have greater weight in determining credit scores. Your payment history and how much you owe carry the most weight. Approximately 35 percent of the score is derived from your payment patterns and around 30 percent from the amounts owed. If you can get a handle on these two items, you’ll find the other scoring factors will take care of themselves.
Your payment pattern simply means paying on time. If you’ve never had a late payment on a credit account, then this fact alone contributes significantly to your score. If you’ve had a late payment or two recently, this fact will also hit your score fairly hard, especially if this late payment is within the past two years. A recent late payment on a car loan, for example, can drop a 700 credit score to 650 in a heartbeat. Another late payment? You’re in the low 600s. But if you’ve paid your accounts on time, you can also expect your credit score to be high. As long, of course, as your other factors aren’t being damaged.
The next most important scoring characteristic is your account balances, sometimes called your “available credit.” Credit scoring companies want to see that you have credit accounts, but they don’t want to see your balances approach or exceed your credit limit. For instance, say you get a new MasterCard with a $10,000 credit limit. Your credit score will drop if you approach the limit, and drop further still if you exceed it. Making minimum monthly payments with high balances on your credit cards will slowly erode your score. Go over your credit line and you’ll really knock your score down. Ideally, keeping your amounts owed to approximately one-third of your credit lines inflates credit scores. Interestingly, having a zero balance on a $10,000 credit card does nothing for your score compared to having a $3,000 balance on that $10,000 card and making timely payments.
6.3 WHAT THINGS IN MY PAYMENT HISTORY AFFECT MY CREDIT SCORE?
Credit scores can be affected by how often you make your payments on or before the due date. The scoring model reviews the existence of any late payments and how late they actually were in 30-day increments. A 90-day late payment will hurt your score more than a 30-day late payment. That is, unless the 30-day late payment was last month and the 90-day late payment was five years ago. Remember that scores concentrate more on recent behavior than on old behavior. Payment history also covers collection accounts or charge-offs (bad debt the original creditor has simply given up hope on collecting) and includes searches of public records for bankruptcy filings, judgments, or tax liens.
6.4 WHAT ABOUT MY AMOUNTS OWED? WHAT IS MOST IMPORTANT?
Amounts owed is relatively easy to identify: It’s how much you owe compared to how much you’re allowed to borrow. But here again, conventional credit wisdom and credit scoring butt heads.
Advice just a few years ago suggested closing any outstanding accounts that had zero balances, or if there were accounts with small balances, paying them off and closing them out. Why? When human beings underwrote loans to loan credit standards, this might have been good advice. Heck, it’s still good advice, but the impact on a credit score could backfire. Since amounts owed account for nearly a third of your credit score, you need to be very careful how you treat this scoring factor.
Underwriters can look at available credit as a bad thing, regardless of whether you’ve used it. If you’ve got $50,000 of credit available to you among various credit cards, then who’s to say you won’t go out and charge every bit of that just after your home closes? If you had debt-ratio issues with simply buying the house, having all this available credit means that there’s the possibility of your using every dime of it buying new drapes, carpeting, furniture, and a nifty new widescreen HDTV.
At least that’s what an underwriter would take into consideration. Even though you’d never charged that amount in your entire life, the simple fact that you could would make an underwriter afraid. So in this case it’s good advice: If you have old accounts you’re not using, cancel them out so an underwriter won’t be tempted to make you close them out before your loan approval. But that’s not necessarily the case these days in the world of automated underwriting and credit scoring.
Remember that having a strong “available credit” factor can increase credit scores. If you have a $20,000 credit line on various accounts and your balances only add up to $5,000, then you have 80 percent of your credit available to you. That pushes up your score. But if you cancel some accounts, thereby reducing your available credit limit to, say, $8,000, then you’ve used two-thirds of your available credit—twice as much as the magical “30 percent” guideline. Your credit score can suffer. If you have cards that haven’t been used in a while, leave them alone and keep your available credit at higher amounts.
6.5 HOW DO I FIND OUT WHAT MY SCORE IS?
That’s easy. It wasn’t too long ago that obtaining your own credit score was nearly impossible without applying for a mortgage loan first. Now it’s as simple as logging onto any of the websites of the three repositories.
Or you can go to a site called AnnualCreditReport.com and get your credit score.
This service pulls your credit from all three bureaus. The credit report is free, but you must pay a small fee for your score (as you would at the individual credit sites).
The Fair and Accurate Credit Transactions Act (FACTA) is the law that allows you to get a free copy of your credit report every year, regardless of any credit declination. It also lets you see your credit score. Is it important to find out what your score is? Yes, but it’s more important to review your credit report first. I know you’ve heard this a million times, but the first thing to do when getting ready to shop for a home is to check your credit report. The reason is not to see your score but to check for errors that are hurting your score.
However, it’s important to understand that the scores you have access to are not exactly the same as what a mortgage company pulls. When consumers access their own credit score, it’s most often what is referred to as a Vantage Score, the name assigned to a consumer credit-scoring model that is prepared by the three major credit repositories in an attempt to compete directly with FICO. Mortgage lenders do not use Vantage Scores and use the FICO score designed specifically for mortgage companies.
6.6 HOW DO I GET A CREDIT SCORE?
By buying things on credit. Again, these computer models need a credit history of typically two years. I’ve seen credit reports with no score available simply because credit hadn’t been established or hadn’t been established long enough. If you’ve got a gas station credit card and have had it only a few months, you won’t have a score, even if you’ve used the card. But applying for credit, using it, and paying it back gets your score established. You also need to have a Social Security number.
6.7 WHAT’S THE MINIMUM CREDIT SCORE I NEED TO QUALIFY FOR A MORTGAGE LOAN?
Fannie Mae and Freddie Mac set minium credit scores at 620 while FHA loans have a minimum score of 500. There are no minimum credit scores required for VA and USDA mortgages. In order for a loan to be eligible for sale in the secondary markets, the representative score must meet these minimums. However, lenders can also have their own internal guidelines, asking for a higher credit score than what is prescribed in the lending guidelines. A mortgage company issuing a conventional loan can ask for a minimum credit score of 640 if the down payment is less than 10 percent, for example. Lenders can raise the credit score bar but cannot lower it. That is, if the lender intends to sell the loan later on.
As long as the lender applies its guidelines universally, the lender has the right to have credit score minimums higher than other lenders or require additional items in order for borrowers to qualify for a loan. These additional qualifications are called “Lender Overlays,” and many lenders have them. This also means that if you apply for a mortgage at one company and the minimum credit score is 640 and yours is 630, you should find a lender that uses the 620 minimum.
I’ve spoken with countless customers who either didn’t buy a home or put it off for a long time because when they got their credit score they took it upon themselves to “decline” and didn’t even apply for a loan. Similarly, sometimes people don’t apply for the mortgage they want because they think their debt ratios are too high. A recent customer called me wanting to apply for a mortgage but he knew his credit wasn’t all that great. High debt load, a couple of late payments, and not much available credit. He was right; his score was low at 581. Unfortunately for many people, once they see a score they consider “low,” they give up without ever trying.
The guy with the 581 credit score? He got approved for a $185,000 loan. He had some other factors that offset the low credit score—mostly a hefty down payment—but the point is that he got approved. Let the lender make the determination for you.
Today, most conventional mortgage loans ask for a minimum credit score of 620 as do government-backed loans, but again exceptions can be made.
6.8 WHAT IF MY LENDER TOLD ME I COULDN’T QUALIFY BECAUSE MY CREDIT SCORE WAS TOO LOW?
Lenders can establish almost any criteria they desire as long as they don’t discriminate in doing so. If lenders decide to offer better pricing to someone with an 800 credit score, they have every right to do so. If they have a loan program that requires little or no documentation, they might also offset the risk of no documentation with a credit score, and so on. If your lender said you couldn’t qualify because of a score, it was most likely due to the fact that the loan you applied for had some special characteristics that conventional loans didn’t have.
In these cases, a loan officer will typically ask for an “exception” to loan guidelines and get you approved anyway. What exactly is an exception? Let’s say a special loan program you want has a minimum credit score of 760, but your score is 740. Instead of calling you up and giving you the bad news, your lender will ask for “compensating factors” to be used to override the 760 credit score requirement. You will then be asked to bolster your case for the underwriting exception by providing documented details about other facets of your financial life.
Do you have a lot of money left in the bank after your loan closing? Are you upwardly mobile with higher earnings ahead? Do you have a good down payment rather than just the minimum required? Have you been in the same line of work for a long time? Such compensating factors are used when a loan officer sends your loan for an exception request to override a credit score requirement.
6.9 HOW DO I KNOW HOW MUCH TO CHARGE AND HOW MUCH TO PAY OFF?
The secret formula appears to be 30 percent. Keep your monthly credit balances around 30 percent of their limits. Is $10,000 your limit? Keep a $3,000 balance. This percentage seems to work best. Yes, you need to charge things on credit and pay them back, but keep a balance. Charge nothing and you’ll never establish a payment history. Charge it all and you’re approaching your credit limits, hurting your score.
The 30 percent level is sometimes looked at differently, from the perspective of “available credit” instead of your credit limit, but with the same result. Available credit is just another way of saying that your current balances are 30 percent of your limits, which means that you have 70 percent of your outstanding credit lines available to you.
Credit scores attempt to take a “snapshot” of a recent two-year period and factor in all your various payment patterns to get a true picture of your credit behavior. Don’t expect that you can get any significant change in your credit score by paying off or paying down your credit balances. It would only be effective if you did so routinely over a period, which would more accurately reflect your credit habits. But don’t pay everything down to 30 percent of your credit lines and expect a change in your score the next day.
6.10 WHAT ELSE AFFECTS MY CREDIT SCORE?
Your payment history and amounts owed are the biggest factors, but other items can affect your score as well. One of the more common scoring items people see is “number of credit inquiries.” This scoring factor takes into account how many times you’ve applied for credit over the past couple of years. Lots of new credit inquiries could mean that, for whatever reason, you needed to establish new credit lines. You didn’t have enough money to buy what you wanted to buy, so you put it on credit. Lots of recent credit accounts might also indicate a potential for default. A person with high debt load and lots of credit payments is a greater risk than someone with fewer accounts.
Another factor is the type of credit account you’ve opened. Real estate accounts (mortgages) have a more positive impact on your credit score than credit from a department store. Furthermore, credit accounts from consumer finance agencies that loan smaller amounts of money at higher interest rates can have a negative effect on your score. Finally, how long someone has had credit affects a credit score. Scores will be higher the longer a consumer has used credit.
6.11 HOW CAN I INCREASE MY AVAILABLE CREDIT WITHOUT OPENING UP NEW ACCOUNTS?
You can’t. But you can ask for an increase in credit limits. Perhaps one of your current lenders will raise its maximum credit limit for you, so at the very start you might contact your credit provider and ask to have your credit line increased.
But on the whole, without opening up new accounts, it’s really impossible to increase available credit without increasing both inquiries and the number of new credit accounts. New credit card accounts can hit your credit score in a bad way. If you do open up new lines of credit, it may be to your advantage to leave them alone for at least a year, to let the account season and begin to work in your favor. It doesn’t make sense to open up trade lines to increase available credit. Increasing your available credit only works on existing accounts with relatively low balances.
And it works even more in your favor if you’ve had the account for several years. If there’s a trick to this double-edged sword it would be to identify your two or three oldest credit card accounts and pay those balances down to about one-third of your available credit line.
6.12 I’VE APPLIED AT MORE THAN ONE MORTGAGE COMPANY. WILL ALL THOSE CREDIT INQUIRIES HURT MY SCORE?
Not if the inquiries are for the same mortgage. An “inquiry” occurs when someone or some business inquires about your credit by contacting the credit bureaus. Let’s define what is and is not a credit inquiry. First, those reports that you request yourself to check your credit are not counted as an inquiry. For instance, you apply for automobile financing with your credit union but also let the dealer check your credit to see if you qualify for financing. This will be read as an individual inquiry, not two. The same applies to mortgages. Applying for a mortgage at more than one place because you’re shopping for a mortgage won’t be viewed as multiple inquiries as long as it’s for the same loan and within a reasonable time frame, say, within the past month or two. A mortgage inquiry for a home improvement loan two years ago and for a refinance last month will be viewed as two separate inquiries because they’re not for the same loan and they’re far apart in terms of time.
So the answer is no. If different mortgage companies check your credit for the same transaction, then you should see no negative impact on your score. If you thought about refinancing earlier this year, changed your mind, then started all over again six months later, then yes, you could see your credit scores drop.
6.13 HOW DO I FIX SCORES THAT ARE ARTIFICIALLY LOW DUE TO MISTAKES?
The way you can get incorrect items off of your credit report is the very same way you get your score corrected, except for one thing: You have to literally request this score be recalculated for you, and there may be a marginal charge for doing it, say, $40 or so. Why should you have to pay for the error? Good question. I don’t see why you should, but currently you can expect to have to pay a charge. Not just the $40 for the mistake, but $40 for each credit bureau that’s reporting the incorrect data. You have to provide your documentation, just as with any other credit dispute, and have your credit score “rerun” as if the mistake never appeared.
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There’s a service that the credit reporting agencies offer their lenders called the “rapid rescore.” Even if you were successful in getting the error fixed, it could take months for the scores to rebuild themselves naturally. Instead, you need to have your scores fixed immediately and permanently.
I had a client who experienced a bankruptcy, and there were several accounts that were showing up as outstanding collection items, even though they were discharged through the Chapter 7 bankruptcy filing. The loan program she was trying to qualify for was a special program that required zero down and was for investment properties. Her credit scores, all of them, were below 620, which was the minimum score needed for the loan. She was closing in less than 30 days and either had to get her scores fixed or lose the house she wanted to buy. I asked her for the complete copy of her bankruptcy papers, which showed all the accounts that were discharged and the date they were discharged. I reviewed the papers and, sure enough, the credit reporting agencies were making some serious errors.
I contacted the credit agencies, forwarded the bankruptcy discharge papers, and asked for a rapid rescore based upon the new information. Within three business days we had our results, and her credit scores were above the minimum. In fact, her middle score, which we used for the loan, was 681.
A rapid rescore is not an automatic. Just because you ask for the rescore doesn’t mean you’ll automatically increase your score by 30, 40, or even 50 points or more. There are too many variables to guarantee any result, but it’s worth the try.
6.14 IF THERE ARE SEVERAL MISTAKES ON MY REPORT, DO I GET THEM ALL CORRECTED? HOW DO I KNOW WHICH ONES TO CORRECT?
Your loan officer should help you with that, but you should only submit a rapid rescore to the two bureaus with the highest current scores. Why? Since lenders use the middle score and not the highest or lowest, you should try to increase scores that are already higher. Rescoring costs money, and it gets more expensive with each line item and bureau you contact requesting a score change.
Don’t dispute old data that might be a mistake. Instead, ask for a rescore on the most recent item(s), since scores concentrate more on recent activity and not old activity. And remember that rescoring only works on mistakes, not disputes. If there’s an item that you disagree with but don’t have the documentation to back up your position, such as bankruptcy papers or copies of canceled checks showing payment, then don’t bother.
It’s also important to remember that rescoring is a service the credit agencies extend to the lending community; it’s not a consumer service. This means you’ll need to have your loan officer request a rescore on your behalf. If your loan officer doesn’t know what a rapid rescore is, you’ll need to find one who does.
6.15 I’M A SINGLE PARENT AND A MINORITY. DOES THIS STATUS HELP OR HURT MY CREDIT SCORE?
Credit scores have no clue as to your marital status, whether or not you have kids, your race, religion, or whatever else. The scores look at credit patterns and public records. They don’t care how old you are, what kind of job you have, or on which side you part or used to part your hair. The only things that really help are the items discussed in this chapter.
6.16 HOW DO LENDERS CHOOSE WHICH CREDIT SCORES TO USE?
That’s a good question. Most lenders will use the middle score, not the highest one and not the lowest one. And there’s a reason. Even though scoring models from all the bureaus are mostly the same, they may not have all the exact same information. If you’ve always lived in Southern California, for example, you may have activity from reporting members (i.e., businesses that issue credit) in a local area that is not reported to, say, the repository in Atlanta. The way lenders use credit scores is to simply throw out the highest number and throw out the lowest number. If there is more than one borrower on the mortgage application, the lender uses the lowest middle score reported.
6.17 I HAVE GREAT CREDIT SCORES, BUT MY SPOUSE HAS LOW CREDIT SCORES. WHAT HAPPENS?
Credit scoring works like a credit report. Conventional loans use the middle credit score from the person who makes less money. Other loans use the credit score from the primary breadwinner. Contrary to popular belief, they don’t average the scores together, add them up, or use the highest score.