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Many people go shopping for a mortgage blindly, without fully understanding the implications of their credit score and the impact on the interest rate and other term lenders are willing to offer. We will shed light on the factors that go into your score, items that will impact it, and why it is important to check for errors.
This may sound dull, but bear with us. The knowledge we are imparting could save you a lot of money.
What is FICO?
This is the most widely used credit score. The name is derived from the fact that it was created in 1989 by a company that was called the Fair Isaac Corporation, hence FICO. In fact, it is used by approximately 90% of the top lenders in the country in order to assist in making credit decisions.
FICO scores range from 300 to 850. You credit risk to the lender is lower the higher the score. In other words, the number sums up several factors to evaluate your riskiness from a lender’s point of view. You must have enough information, particularly recent data, in order for the credit bureaus to calculate a score. This typically means having at least one account open at least six months.
There are three major credit bureaus (Equifax, TransUnion, and Experian). FICO scores are determined based on the information obtained at these companies. Therefore, it is not unusual to have slightly different scores. For instance, the notification of a late payment may vary or missing an account. If there is a large difference, this warrants further investigation. While it may be legitimate, it likely means the agencies have different information. It is also important to realize that your credit score will change over time.
We will discuss the various information that goes into determining your score.
Components of your credit score
The exact formula for calculating credit scores is kept under wraps. However, FICO has disclosed the various components and weights.
The largest portion, at 35% is payment history. Various items such as bankruptcy, liens, charge offs, foreclosures, and late payments can have a significantly negative impact on your score. The second largest component (30%) is debt burden. There are a number of different metrics, including debt to limit, the number of accounts with balances, and the amount owed on various types of accounts. In other words, it is a measure of credit utilization. If you max out your credit cards, your score will be lower. However, if you use less than 10%, that is a major plus. This is followed by length of credit history (15%). The longer you have had credit, the higher your score. If you are new to using credit, your credits score will be lower.
The next two components are types of credit used and recent searches for credit, at 10% each. There is a benefit to having a history of different types of credit, such as mortgage and revolving (e.g. credit card). On the other hand, many credit inquiries, particularly within a short period of time, will harm your credit score. However, this is misunderstood by many. Only “hard” inquiries, such as when consumers apply for a credit card, loan, or mortgage, count against your score. Therefore, checking your score for errors or employment, will not lower it. Furthermore, if you are shopping around for a mortgage over a short period of time, your score will not meaningfully decrease since it is considered only one inquiry.
What does this mean for my rate?
If you have a score above 760, this is excellent. If it is above this threshold likely won’t get you better terms. However, if you are in the 500 range, your mortgage rate could be about 4% higher. It is important to keep in mind that each lender will have its own rules. The difference on a $500,000 mortgage is over $1,300 a month assuming a 4.5% rate at the low end for a 30 year mortgage.
Simple rules to improve your score
Simply, pay your bills on time, keep your credit card balances low (paying it off fully every time will also save you interest charges), and don’t open too many new credit lines, including credit cards.
Credit scores are important, and a low score will cause lenders to charge you a higher interest rate. If it is very low, you may not get a loan altogether. This was particularly true a few years ago when lending became very tight.
However, it is not the sole basis for making a lending decision. Nonetheless, obtaining your credit score to check for accuracy, particularly in this era of fraud, is very important, and not just if you are shopping for a mortgage. Under the Fair and Accurate Credit Transactions Act (FACT, each legal U.S. resident is entitled to a free copy of his or her credit report from each reporting agency once every 12 months.