Credit Scores

In mortgage underwriting, there are three primary considerations – the “three C’s”. Credit, Capacity to Repay, and Collateral. Of these, credit is the one people think of most often. The credit category encompasses several different components, but credit scores may be the most meaningful and the most misunderstood gauge of creditworthiness.

Why are Credit Scores used?

Credit scores provide lenders and consumers with several advantages. Most notably credit scoring models consider only actual, empirical data. This has the benefit of removing unimportant or potentially discriminatory factors from the decision-making process.

A credit score employs data from five primary categories, which are described below. What doesn’t appear are factors such as employment and income (these are considered separately in the underwriting process), gender, or racial and ethnic distinctions. Ideally, credit scores help remove some of the problematic discriminatory components that have historically kept underserved borrowers from accessing the credit they deserve. According to a 2010 study by the Federal Reserve, “credit scores do not have a disparate impact across race, ethnicity, or gender.”

Credit scores also give lenders an important metric to evaluate their lending decisions. Repayment histories can be compared to credit scores to determine what score levels lead to positive and negative repayment histories.

What is a Credit Score?

A credit score is a numerical representation of the data in your credit report. Credit scores based on information from the three nationwide credit bureaus first came into use as a way to manage credit risk in 1981 and have become increasingly important over the years. Mortgage lenders began considering credit scores in the mid-1990s.

The credit scoring model was developed by Fair Isaac Corp, now known as FICO (hence the term FICO Score). The FICO Score model is an algorithm that collects and considers several factors and distills them into a single number.

It’s important to understand that credit scores are not the only credit information that lenders consider. Significant events such as bankruptcies or foreclosures are given special additional consideration and late payment history on mortgage loans can also be factored in.

Finally, credit scores do not include information on income, employment, and other non-credit items.

A Credit Score is Not a Perfect Metric

Your credit score is a snapshot of your credit report data at a specific period in time. The scoring models don’t factor in information like whether you pay your credit balances in full each month. The models are only calculating credit scores based on the data reported to the bureaus on the specific day of the month each creditor reports.

Let’s assume, for example, that your credit card companies report to Equifax, TransUnion, and Experian all on the 15th of the month. Let’s also assume that you make your payments on the 25th of the month and pay your balance in full. The credit scores will be based on the balance outstanding on the 15th, even though you routinely pay in full each month.

Think of it this way. If you take a photo of someone running a 100-yard dash, that photo will show where that runner is on the track. It will not show how fast she is running or what her overall time will be. Credit scores work like that, and are therefore a somewhat imperfect representation of someone’s complete credit profile.

Credit scores also do not consider reasons for someone’s credit behavior. Many people suffer temporary or unusual circumstances that can lead to damaged credit. Often, they recover from these problems, but the scoring models don’t know or care about the reasons for the damage. They only show the credit history as it occurred.

What goes into a credit score?

Five factors go into your credit score. These factors are interrelated, which makes it difficult to know how changing just one will impact your overall score. For that reason, it’s important to manage all the various aspects.

Keep in mind that your credit scores are based almost exclusively on traditional credit – that is, your management of borrowed money. Monthly payments for things like rent, cell phone, utilities, etc. don’t typically impact your credit scores. At least one of the major credit reporting agencies offers a way to improve your scores by including some of these items, but the mortgage credit score doesn’t use that particular scoring model.

Payment History – 35% Impact

Making your payments on time has the greatest positive impact on your credit score. Payments aren’t considered late unless the payment posts 30 days past the due date. It’s always best to make any payment before the due date, but a payment made a few days past the due date won’t negatively impact your credit score. Late payments are evaluated in 30-day increments – 30 days, 60 days, 90 days, and 120 days. The later a payment, the greater the negative impact on your credit scores.

Further categories of delinquency are also measured. If an account goes to collection, charge-off, or foreclosure, an even greater negative impact occurs. A bankruptcy filing is another item that does significant damage to credit scores.

Paying off balances each month rather than only making minimum payments can have a positive impact. Delinquencies that occurred in the last two years carry more weight than older items.

Outstanding Credit Card Balances – 30% Impact

The amount of outstanding credit relative to the maximum available credit on revolving debt is the second most impactful factor in credit scoring. This tends to also be the one that has the impact most surprising to consumers.

Many people with perfect payment histories have depressed credit scores because they have run up high balances on credit cards. “Maxing out” credit cards seriously decreases credit scores, even if the payment history is pristine.

Ideally, consumers should keep balances as close to zero as possible, and definitely below 30% of the available credit limit. If staying below 30% isn’t realistic, try getting the balance down as low as possible, and never go over your credit limit.

Credit History – 15% Impact

This indicates the length of time since a particular credit line was established. A longer credit history benefits Borrowers. This is an area that often hinders young people new to the world of credit, and can’t be improved upon except over time.

Type of Credit – 10% Impact

A mix of credit, such as an auto loan and a credit card, is more positive than a concentration of debt from just credit cards. Additionally, the scoring models tend to treat credit accounts from finance companies more negatively than credit received from banks and major credit card issuers. Since many department store credit card issuers are finance companies, those accounts can be worse for your credit scores than a more favorable account type.

Inquiries – 10% Impact

Each inquiry made on a consumer’s credit within 12 months can deduct points from a credit score. The biggest credit score reductions come when there are multiple inquiries for a variety of credit types. Someone applying for car loans, credit cards, personal loans, etc. in a short time could be predictive of excessive credit usage and future credit problems. Personal credit inquiries do not impact scores.

Credit Score Ranges

The most widely used credit score is known as the FICO® Score, which ranges from 350 to 850. The higher your FICO® Score, the better. Another model, known as a VantageScore®, is often provided to consumers, but that model is not the one used by the mortgage industry.

Different mortgage products have different credit score requirements, and different scores can impact the interest rates for mortgage products in different ways. Many mortgage products have minimum credit score requirements and conforming loan interest rates in particular are very sensitive to credit scores. The best rates are reserved for applicants with higher credit scores – 740 or higher. Lower credit scores result in higher interest rates. Government loans such as FHA, USDA, or VA loans are more forgiving of lower credit scores.

If your credit score is high enough to qualify you for a lower interest rate, this could save you thousands of dollars over the life of the loan.

Where can you get your scores?

Your free annual credit report, provided at www.annualcreditreport.com, does not include FICO® Scores, so you may obtain your actual score by one of the following three methods:

1. Check Auto Loan of Credit Card Statements. Many creditors are now providing scores on monthly statements.
2. Talk to a Non-profit Credit Counselor. Many Credit Counselors will provide your credit report and score in conjunction with an initial consultation.
3. Purchase your score. You may purchase your score directly from myFICO.com or directly from the three credit reporting agencies: Experian.com, TransUnion.com and Equifax.com.

The credit scoring models (they’re not all the same!)

If you’ve checked your credit score and then applied for a mortgage, expect the mortgage lender to get a different credit score than what you received. The credit score most consumers get is known as a “consumer score” or “educational score” and is based on one of many scoring models.

Mortgage companies are required to use a particular score model that is older than the most up-to-date versions.

Different credit scoring models apply to different types of credit being applied for. Mortgages, car loans, and credit cards all have their scoring models. Additionally, three credit bureaus collect data and calculate credit scores. The data in each bureau may not be the same (not all creditors report to all three credit bureaus, and data can be reported at different times so balances don’t always match). This difference in data can lead to multiple credit scores, even when the same model is used.

What is a “Good Score”?

The mortgage industry standard is to assign the middle score out of those reported by the three nationwide credit bureaus as the “representative” credit score for each borrower. When more than one borrower applies for a mortgage, the lowest representative score for each borrower is used for underwriting and interest rate pricing.

For mortgages, excellent credit scores are those 740 and greater. An average credit score ranges from 680 – 739. Scores in the 620 – 679 range are acceptable for most programs, but a score below 620 has very limited mortgage options.

Managing your credit is a crucial component of your overall financial plan. On-time payments over time, keeping balances low, and utilizing the right types of credit, all work in your favor as far as your credit score is concerned. A great credit score will save thousands of dollars over a lifetime with lower rates and reduced interest payments.