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Whipping your credit report into shape is part of preparation, but is material for its own chapter. Let’s start with the big questions, then start explaining.
First of all, what is a credit score?
A FICO score is nothing more or less than a prediction of the likelihood of a particular consumer having a 90 day late in the next 24 months. It is a snapshot, based upon your position and your balances as reported at the exact moment it was run.
What is FICO?
A score from Fair Isaac Corporation (aka Fair Isaacsson Corporation), a firm that has built what they have demonstrated to be the most effective predictive model, and is therefore used in predicting whether or not a particular consumer is an acceptable risk. FICO scores for mortgages run from 300 to 850. There are different models for different credit requests, weighted differently. For instance, the FICO for auto loans goes up to 900. A consumer screen that you run on yourself will pretty much always be higher than the ones anyone else runs on you for any purpose, so be aware that the scores you see for yourself when you run your credit report online are essentially guaranteed to be higher than the ones the loan officer and underwriter sees. A rental screen for landlords is different for a mortgage screen for lenders, as they are for different things. That said, it should be intuitively obvious that given the fact that a mortgage FICO is intended to predict whether you’ll make your housing payments on time, it very heavily weights mortgage and or rental payments being made on time.
Who are Experian, TransUnion, and Equifax?
They are the ‘big three’ credit reporting agencies. They all use the same FICO model, but there will be slight variations in the reports, and therefore, in the scores they generate. The general rule is that mortgage lenders will drop the top and bottom scores of the big three, and use the middle score. If only two of the big three report FICO scores for you, they will use the lower of the two. If you don’t have FICO scores from at least two of the big three, your loan will be declined. It’s no fun when it happens. I had some married clients who were both highly paid executives. They had one credit card with a zero balance and a private mortgage, and had never ever had a late payment, but none of the big three were reporting a FICO on them. Result? Nobody would lend to them until they opened another credit card, at which point FICO scores popped up well into the ‘A paper’ range.
How do you get a credit score?
In general, you must have at least two different credit lines in order for a credit bureau to report a score. This doesn’t mean monthly utilities. This means credit accounts – accounts you have opened where you have already received the goods or services, and are making payments. You want your credit accounts reported to all three bureaus. They can be either single event or revolving accounts. A single event is something like you bought a car or furniture, and financed it. You make regular monthly payments, and when you’ve paid off the initial amount, the account is closed. A revolving account is like a credit card – you have a limit, and a minimum payment based upon your current balance. As long as your balance is less than your credit limit, you can use it to buy additional things later. If you pay it down, you can re-use it up to the amount of your credit limit. If you pay it all the way off, the account is still open and you’ve got your entire credit limit open to you. If your balance equals your limit, you can’t buy anything more on that line of credit until you pay it down. Revolving accounts are typically open ended – they can go on for as long as both parties are still happy with the relationship. I’ve seen revolving accounts that have been open for forty years.
What goes into a credit score for mortgages?
In increasing order of importance, Inquiries, type of credit, length of credit history, balances, and payment history.
Inquiries covers how many times you’ve asked for credit in the last twelve months. The logic behind this is that if you’re looking for a lot of credit, that generally means you’re not as good of a risk. There is an exception to this: Mortgage inquiries. Since most people are only shopping for one mortgage at a time, counting each separate inquiry would severely discourage shopping around, as well as favoring the first company you asked if you did, because subsequent inquiries would drop your credit score. I remember back when I first started, some companies would re-run applicants credit scores if you were close to a critical threshold, so as to drive you below that threshold for later inquiries. That all changed thanks to the Mortgage Broker’s Association, who lobbied Congress to change it. Now all mortgage inquiries within a thirty day period are treated as one inquiry. This enables consumers to shop around between mortgage providers without hurting your credit score. A note of caution: Many banks therefore have two different inquiry codes: One that is used for mortgage inquiries, and one that’s used for everything else. You want to make certain they use the one that says ‘mortgage inquiry.’ Since brokers and correspondent lenders only deal with mortgage credit, they only have one code, for mortgage inquiries. (I’ll explain the differences between the three sources of mortgage loans later).
There is a difference between an inquiry done by a current creditor for purposes of continuing an existing relationship or who somehow gets the information to run your credit on speculation (‘soft inquiries’) and those inquiries initiated by you for purposes of obtaining additional credit (‘hard inquiries’). Soft inquiries do not, in general, count against you as you didn’t ask for your credit to be run and you’re not looking for more credit. Hard inquiries do count, up to a limit of three to five, depending upon your credit history and length of credit.
Type of credit used concerns the terms of the accounts themselves. They are looking for a reasonable balance between types. The absolute worst accounts for your credit score are those ‘no payments for twelve months!” accounts. Some may be no payments for longer or shorter, but they’re all poison to your credit score. The reason is people who can’t afford to make payments right now get those credit accounts, so everyone who has them suffers by association. A lot of the very highest credit scores I’ve seen have been people with nothing but revolving accounts who always stay well under the limit. So don’t get one of those ‘no payments for twelve months’ accounts. If you have one, pay it off.
Length of credit history is where credit cards and other revolving accounts really shine. The credit bureaus look at how long each of your accounts has been open, they add them up, and divide by however many there are. This yields average length of credit history. Anything over 5 years is golden. As I said above, I’ve seen some credit card accounts that people have had for over forty years. By comparison, a furniture or auto loan may be three or four or five years, then it’s over. Just as it’s getting to the point where its continued existence is a net benefit, it’s closed and gone. Closing open accounts is something to avoid when you’re getting ready to apply for a mortgage. It doesn’t matter if you don’t use it, as long as it doesn’t cost anything, there’s no reason to close it, and closing it can hurt your credit score by up to eighty points. On this scale, it can be very worthwhile to pay an annual fee for one more year for a card you’ve had open for a long time. If paying a $35 fee means you don’t get dinged even a quarter point on a $300,000 mortgage, that’s about 750 dollars you just saved by paying that $35, and a quarter point is a very minor consequence on the scale of mortgage costs. Dropping your credit score eighty points can mean the difference between the top level ‘A paper’ and paying a significant adjustor. If you’re lower down on the ‘A paper’ scale, it can move you from ‘approved’ to ‘declined’. That’s kind of an especially big deal right now when loans that are lower down on the food chain are very difficult to find, and if you can find them, the cost and rate differentials can be both two or three points on the cost and two to three percent or more on the rate. (There is always a trade-off between rate and cost, a point I will hammer home repeatedly, but as this is your first introduction to the concept just be aware that you can trade one for the other, but I am talking about surcharges to both at the same time here.)
Copyright 2015 Dan Melson. All Rights Reserved.
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