Understanding Credit is one of the most important components in the mortgage approval process.
Lenders look at a borrower’s credit score, number of open accounts, payment history, type of credit borrowed and a series of other factors when determining what level of risk to assess to each lending scenario.
According To Wikipedia:
A credit score in the United States is a number representing the creditworthiness of a person or the likelihood that person will pay his or her debts.
The Fair Isaac Corporation, known as FICO, created the first credit scoring system in 1958, for American Investments, and the first credit scoring system for a bank credit card in 1970, for American Bank and Trust.
The three credit reporting agencies in the United States of America, Equifax, Experian, and TransUnion, collect data about consumers used to compile credit reports. The credit agencies use FICO software to generate FICO scores, which are sold to lenders. Each individual actually has three credit scores at any given time for any given scoring model because the three credit agencies have their own databases, gather reports from different creditors, and receive information from creditors at different times.
In the United States, a resident is permitted by law to view their credit report once a year at no charge by visiting the website AnnualCreditReport.com. The individual’s “credit score” information is available for an additional fee from each of the three credit reporting agencies. In addition, the Fair Isaac Corporation sells FICO scores directly to consumers using data from Equifax and TransUnion.
A FICO score is between 300 and 850, exhibiting a left-skewed distribution with 60% of scores near the right between 650 and 799.
Once credit has been established and maintained, credit scores are based on five factors to varying degrees: payment history (35%), total amounts owed (30%), length of time (15%), type of credit (10%) and new credit (10%).
The largest impact on credit scores is payment history and amount owed, which is why it is important to pay bills on time.
Debt should be kept to a minimum and funds should be moved around as little as possible. It may be beneficial to leave all accounts open, even if they have a $0 balance.
Different types of credit (ie. mix of credit cards, installment loans and fixed payments) can also be beneficial to a credit score.
However, too many installment loans can negatively affect credit.
Although time is a necessary factor for improving credit scores, this can be controlled by keeping the accounts that are opened during the same time period to a minimum.
By following these guidelines over an extended period of time, credit scores can be maintained and improved in order to improve the borrower’s loan potential and interest rate.
Understanding Credit: Key Factors That Impact Your Score
1. Payment History (35%)
It is essential to pay your credit bills on time. Every 30 days late, collection, judgment, or Bankruptcy significantly drops your score.
2. Amount You Owe Compared to Balances (30%)
Your available credit compared to the amount owed. It’s a good rule-of-thumb to be at 40% or less of the available balances
3. Length of Credit History (15%)
Easy rule-of-thumb: the longer your accounts are open, the more positive impact it will have on your overall credit score. In fact, if you happen to have a card that is over 10 years old with even a little activity, it would probably be a bad idea to close that card.
4. Mix of Credit (10%)
Generally speaking, if you have loans, such as a car loan, as well as open credit cards, it helps prove to creditors that you have experience borrowing money.
5. New Credit Applications (10%)
There is a model that compensates for people shopping rates on home and car loans, but it can hurt your credit score to have multiple reports pulled in a short amount of time.
Factors That DO NOT Impact Credit:
- Employment History
- Marital Status
- If you’ve been turned down for credit
- Length of time at current address
- Whether you own a home or rent
- Information not contained in your credit report
Several factors can be used to establish credit initially, including bank accounts, employment history, residence history and utility bills.
Although they are not reported directly to credit bureaus, bank account history is important to lenders for first time loans and should be kept in good standing.
While they are also not reported to credit bureaus, utility bills (such as electric, telephone, cable and water) can also show a lender the risk associated with a new borrower.
Credit may be initially established through a bank, in which a credit card is linked to a specific amount of money deposited in the bank. If the credit card is not kept in good standing, the bank can then take the secured funds for payment.
Initial credit may also be established with a department store credit card (for example), but borrowers should beware of the high interest rates associated with these cards and pay off the balances in full.