Credit Scores and How You Can Improve Them

Credit scoring was developed based on the analysis of millions of homeowners and their payment histories. What is the likelihood of Mr. and Mrs. Homeowner paying their mortgage on time or getting behind in payments or stopping payments completely and losing their home? This is what every lender wants to know about a new borrower; Will they pay their payments? So analysis was conducted on millions of borrowers by Fair Isaac Company (from which we derive the name FICO).

In analyzing the credit histories of millions of borrowers, they found relationships between a borrower's late payments, their balances of revolving debt (such as credit cards), length of credit history, the type of credit they have, how often they try to establish more credit and their ability to repay those debts.

Late Payments
Balances
Length of Credit History
Type of Credit
Inquiries

Based on these studies, a rating system was developed which could accurately predict the likelihood of a borrower not paying his/her payments. These are called the FICO scores.

Payment History 35%
Amounts Owed 30%
Length of Credit History
15%New Credit 10%
Types of Credit Used 10%

Late Payments

How do they pay their bills? A late payment within the last 30 days affects the score more than one a year old. How often a late payment occurs also matters, as well as how past due the payment was. 90 day late payments lower a score more than 30 day lates.

Balances

Revolving debt such as credit cards is the #1 killer of credit scores. FICO looks at each card and their balances. Balances over 50% of the limit lower the score, then again at 75% and at 100%. The number of open revolving accounts also determines the score. 3 to 5 open accounts is average.

History

The length of time your credit has been established is a determining factor of the score. 30 years is considered a long history. The longer the history, the better the score. If a borrower had a credit card open for 5 years at 19% interest and then moved the balance to a new card at 8% interest, this would have a negative impact on the score. Now, instead of one 5 year history there is a 5 year history and a zero year history (new card) which averages to 2 1/2 years. The length of credit history has just been cut in half. Also since the new card is a low interest rate, if other high interest rate card balances are moved to this card and the card limit is met, this too will lower the score.

Types of Credit

Bank backed credit cards are good. Cards backed by finance companies will lower the score. When credit is offered where no payment is due for a year or more, that credit shows up on the credit report immediately, plus it will report as bringing the account to the limit of available credit. An $8,000 purchase will report as a new $15,000 loan because of the interest added to the loan.

Inquiries

Every time your credit is looked at by a potential lender, your score is lowered. Although the affect is very slight, the reasoning of Fair Isaac is if a borrower has an excessive number of inquiries, he or she will end up with a greater amount of credit. There are exceptions to this. When shopping for a car, if several dealers pull credit, these are only counted as 1 inquiry if they are all within a 7 day period. In the mortgage industry, all inquiries within 30 days are considered 1 inquiry.

Each of these 5 factors has a varying degree of importance on the score.

Bankrupsy

The proportion of overall credit included in a bankrupsy is considered in the FICO scoring. It is important that all accounts which were forgiven in the BK have the statement "Account included in bankrupsy" on the file. Any late payments after a BK have an extremely adverse affect on the likelihood of future credit. Bankrupsies are reported for 10 years from the date of filing.

Collections and Judgments

The credit rating is affected for 7 years from the last activity of the consumer, since 1997. Even if the payment due was only $1.00, if this is paid within that 7 year period, this will be reported as delinquent for another 7 years. Paying a charge off has a positive impact in the rating. Tax liens report for 7 years from date of filing. Child support reports for the lifetime of the debtor.

Based on the credit scoring, Fair Isaac has established a statistical prediction of the likelihood of a borrower defaulting on their mortgage.

A credit score of 660 is considered good. When a credit score falls within 620 and 660, in order to provide preferred pricing, the lender must look for other factors which can "make up" for the lower score. These are called compensating factors such as size of down payment, loan amount compared to the value of the property (LTV), job history, income vs. debt (debt ratio), etc.

A score below 620 limits the financing available for a mortgage. There are restrictions on the amount of funds which will be lent compared to the value of the property (LTV) as well as lenders requiring higher interest rates due to the increased risk.

What Factors Will Affect My Loan?

Credit is the single greatest determining factor for loan approval. The borrower must prove an ability to repay the loan. Ratios of payments to income must be within the standard guidelines. In most cases no more than 50% of after tax income can go to the mortgage payment. Job history has an important bearing on qualification. A 2 year history is a typical requirement for most lenders. If a borrower has less than 2 years at a job but has previous employment in the same line of work, this can be included toward the 2 year minimum requirement. Time in schooling for a particular type of work can be credited toward the 2 year minimum.

Assets

Based on the type of loan, credit history, etc., lenders require a certain amount of equity be in the property. This is a ratio of loan to value (LTV). LTV maximum is typically 95% with good credit, but can even go as high as more than the value of the property-107%. The lower the FICO scores, the more equity will be required in the property. In most cases, lenders want to know the borrower has 1 to 2 months of cash on hand in case there is an income flow interruption, which can be used to make the new mortgage payments. These are called reserves, which vary from lender to lender, with some lenders requiring no reserves.

About the Author

Vernon Alderson is President of 877LoansUSA, a national mortgage company assisting all types of borrowers in obtaining financing. He can be reached at 1-877LoansUSA or at va@877LoansUSA.com . www.877LoansUSA.com