Without a doubt, one of the most important components in the mortgage approval process is a thorough review of consumers’ credit.
Mortgage lenders will review borrowers’ scores, number of open accounts, payment history, types of credit, and a series of other factors when determining the risk level of an applicant during the loan process.
Down payment requirements, loan programs, flexibility on income, and even interest rates can be impacted by even a slight bump in a credit score.
What is a Credit
A credit score is a number representing the creditworthiness of a person or the likelihood that a person will pay his or her debts.
Scores are primarily based on a statistical analysis of a person’s credit history and an algorithm is applied by one of the three credit bureaus: Equifax, Experian, and TransUnion to supply a score ranging from 350 to 850 determining an individual’s creditworthiness.
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 bureaus collect data about consumers used to compile credit reports and use sophisticated software applying an algorithm to generate a credit score, which is then sold to lenders to assist in the approval process. 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.
A FICO score is between 300 and 850, with 60% of consumers with scores between 650 and 799.
Key Factors That Impact Credit
Once credit has been established and maintained, credit scores are based on five factors to varying degrees: payment history, total amounts owed, the average age of accounts, types of credit, new credit, and lastly inquiries.
The largest impact on credit scores is payment history and the 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.
Score Factors by Importance
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 (15%)
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 (5%)
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 With NO Impact
- 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 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.
The most common way of establishing a credit history when starting out is with a secured card. Secured cards are established when a consumer uses their own money to secure a card and each month pay themselves back for charges applied using the card. An annual fee is usually applied to these types of cards to help consumers establish their credit history.
Initial credit may also be established with a department store card (for example), but borrowers should beware of the high-interest rates associated with these cards and pay off the balances in full.
Reviewing Your Credit Report
By law, consumers are entitled to a copy of their credit report once a year. For a copy of your credit report, at no charge, you may visit AnnualCreditReport.com. The individual’s “credit score” information is available for an additional fee from each of the three credit reporting agencies.