Credit scores are one of the largest factors that lenders use in evaluating whether or not to lend money to a borrower. Credit scores are designed to measure the risk of someone defaulting by taking into account various factors in a personâ€™s financial history.
If you are considering purchasing a home one of the things you want to be sure of is the accuracy of your credit report.Â The economic down turn of the last five years has vastly changed the mortgage landscape all across the country.
If you ask any mortgage broker they will tell you that things have changed in the mortgage industry on a monthly basis. Given the increase in foreclosures and short sales lenders have increased their standards when evaluating the potential for default of every borrower.
One of the tools that lenders use to evaluate the borrower to repay a loan is whatâ€™s know as their FICO score. The FICO score was developed by the Fair Issac Corporation. The company was founded in 1956 and their scoring programs are often used to assist lenders in managing credit accounts, detecting credit fraud and automating lending decisions. The FICO score is a standardized approach that helps lenders deliver decisions on loans in an efficient manner.
FICO scores can range from 300 to 850 with 850 being the maximum possible score. According to the FICO scoring system there are five factors that determine a borrowers score:
- 35% â€” A borrowers payment history carries the most weight â€“ Late payments on bills includingÂ a mortgage, credit card or automobile loan, can cause a consumerâ€™s FICO score to go down. Paying your bills according to the contract you signed will over time help improve a consumerâ€™s FICO score.
- 30% â€” The borrowers credit utilization â€“ The ratio of current outstanding debts such as credit card balances to the total available revolving credit ( your credit limit). You can improve your FICO score by paying offÂ debts and lowering your utilization ratio. The closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on your FICO score.
- 15% â€” The length of credit history â€“ As your credit history gets longer, assuming you pay your bills on time, it can have a positive impact on your FICO score.
- 10% â€” The types of credit used (installment, revolving, or consumer finance) â€“ There is some credit given to having a history of managing different types of credit.
- 10% â€” A recent search for credit or amount of credit obtained recently-Â If you have multiple credit inquiries as a consumer seeking to open new credit, such as credit cards, retail store accounts, or personal loans, it can hurt an your score. Applying for lots of new credit in a short period of time is also viewed as risky and can cause a drop in an individualâ€™s score. What should be noted however is that if you are shopping for a mortgage or auto loan over a short period of time you should not experience a decrease in your scores as a result of these types of inquiries. So if you are buying a home and apply to multiple lenders and they all do their credit checks you are not supposed to be penalized.
FICO scores do not take into account a borrowers salary, employment history, where they work, rental agreements, child support or other such obligations or interest rates on any current loans.
Generally speaking a credit score that is over 720 is often considered an excellent credit score.Â A score of 680 â€“ 719 is considered good. A score that falls between the range of 620-679 will usually make the lender scrutinize the file further. Having a score that falls between 585-619 will typically disqualify you from getting the best rates. A score below 584 will make many lenders question whether or not they want to do business with you.
There are actually three companies that report credit scores to lenders. They are Equifax, Experion and Transunion. The scoring of these agencies can often vary quite a bit. Each of the bureaus collects different information on the borrowers which can change the final score. Given how the credit scores can differ from the various agencies if you are falling on the edge of one of the credit ranges it may be prudent to apply to more than one lender. For example if you had a score of 675 at one agency it is quite possible you could be 700 somewhere else which could give you a better rate!
It should be noted that the credit scoring model was slightly altered in 2009 and could effect your score either up or down by 20 points.
In the new model credit problems and issues are ranked according to number and magnitude more specifically than before. The new FICO scoring system also focuses less on how many accounts a borrower has and more on the amount of balances carried.
The statistical models that are used for generating credit scores are subject to federal regulation. The Federal Reserve Boardâ€™s Regulation B (implementing the Equal Credit Opportunity Act), expressly prohibits a credit-scoring model considering â€œprohibited biasesâ€ such as race,Â national origin, sex, religion and marital status. The law also states that credit-scoring models must be empirical and statistically sound. In addition, if a borrower is denied a loan based on credit, the lender must state to the specific reasons for the denial. A statement that the person did not score high enough is not acceptable. Thee reasons for denial must be specific. For exampleÂ there were too many late payments of 60 days or longer.
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So how does one go about improving a FICO credit score to purchase a homeÂ and get the best rates that lenders offer? The answers are actually pretty simple!Â
- Pay all of your bills on time every month.
- Pay off all of your existing debt.
- Unused credit cards should not be closed. This can sometimes lower your credit score.
- Do not open a bunch of new credit card accounts in a short period of time.
A few years ago it was not uncommon to hear of mortgage brokers or credit repair companies doing what was known as â€œdoctoringâ€ a persons credit.
A major portion of the FICO score is set by the ratio of credit used to credit limit.Â What was happening was they would increase the score by simply increasing your credit limit. Some of the credit-repair agencies, for a fee, would report to the credit bureaus that they have opened an account with a high credit limit. The customer could not actually use this account but it would improve the customerâ€™s FICO score due to lowering the balance-to-credit-limit ratio. This is no longer allowed!
When you are starting your home search and getting your pre-approval from a lender one of the other things you should do is get a copy of your credit report from each of the three report bureaus. As a consumer you are allowed to get one free credit report each year from Equifax, Experion and TransUnion.
With this knowledge is hand you should be well armed to position yourself for the best mortgage rate possible.