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You’ve decided to seriously pursue purchasing some real estate. You’ve done all your searching, you’ve looked at many lovely properties, and you have found your ideal one. Chances are you don’t have all the money available to outright buy that piece of real estate, this means that you will have to obtain the financing required to purchase that property. But you must first be approved to get that mortgage loan.
Therefore, you will invariably have to deal with credit scoring when you’re applying for approval for obtaining a mortgage loan. Credit scoring refers to a sophisticated mathematical model that outlines a loan applicant’s credit “behavior” and the credit behavior of other borrowers. Lenders, those responsible for providing the loan, use credit scoring as a way to evaluate the credit risks that you may bring should you be approved for a loan with them. A credit score is a numerical index that represents an estimate of an individual's financial creditworthiness.
The most popular form of credit scoring used in the United States is the FICO score. FICO stands for Fair Isaac Credit Organization, to represent those (Fair Isaac Corporation) who created this credit scoring model. Similar to other credit scoring models, FICO scores produce an output that measures a lender’s ability and likelihood of paying their bills on time. It produces this numerical score by examining such fiscal determinants as:
- Credit history
- Income levels
- Outstanding debt
- Debt utilization history
- Access to credit
A FICO score is expressed in a numerical value ranging between 300 and 850, with the low score representing a high credit risk and the high score representing a low credit risk. A score above 720 is considered to be "good credit", and a score below 600 is considered to be poor. Many loan sources point to a FICO score of 620 as the cutoff point for loan eligibility. Any FICO score lower than 620 does not automatically preclude a prospective homebuyer from obtaining a home mortgage loan, but they are usually only able to acquire a mortgage loan from the private sub-prime market where mortgage interest rates tend to be higher due to the credit risk represented by the borrowers.
Lenders then use this FICO score to determine whether or not a prospective buyer is eligible to receive a home mortgage plan in the first place. The FICO score is also a significant influence on the number and type of mortgage plan options available to the prospective buyer.
Breakdown of the FICO Score
Payment histories on a prospective borrower’s credit history make up 35% of the FICO score. FICO scores weigh recent credit history more heavily than credit actions that took place in the distant past.
The amount of debt the prospective borrower has with creditors make up 30% of the FICO score.
The length of time being a credit user makes up 15% of the FICO score component. As a general rule of thumb, it is better if the borrower has a longer history as a credit user if they also have a history of making timely payments.
Very recent credit history makes up 10% of a borrower’s FICO score. This component analyzes the effort that the borrower went through to obtain loans or credit lines in the previous months before applying for a home mortgage loan.
Analysis of a borrower’s credit makes up 10% of their FICO score. The score reached from this component comes from the mix of credit that the borrower holds such as installment loans (car loans), leases, mortgage, credit cards, and other forms of credit.
Other factors that could negatively affect an individual’s FICO scores include: Delinquencies which refers an excessive amount of accounts being opened within the previous twelve months before applying for a home mortgage loan; Short credit history; Reaching maximum limits on balances on revolving credit; An absence of recent credit inquiries; Tax liens or bankruptcies listed in public records; No recent credit card balances.
FICO scores yield considerable influence for lenders. Studies conducted that measured the correlation between credit scores and mortgage delinquencies (failure to make mortgage payments on time) have shown that there is a significant relationship between a borrower’s credit score and the likelihood of the borrower being ninety days delinquent at least once during the span of their home mortgage loan. As a result from these studies, lenders are now very firm in funding a loan with rates, fees, and terms that precisely match a borrower’s FICO score, which is indicative of their delinquency risk. Due to the increased reliance on FICO scores and other forms of credit scoring, many changes has been seen in the real estate financing industry, primarily the rise of sub-prime lending. This source of lending caters towards borrowers who have less-than-ideal credit.
As a result of this widespread reliance on credit scores in determining credit worthiness by lenders, prospective borrowers are unable to leverage their credit status for a better mortgage loan plan. This is because FICO scores are usually not released to the borrower. However, it is important to point out that FICO scores are not the sole determinant over whether or not a prospective buyer is able to obtain a mortgage loan. Rather, the results of the FICO scores form the guidelines for a lender to determine what mortgage loan options is eligible for the borrower. Therefore, if you have a low FICO score, you shouldn’t be overly worried as your lender’s underwriter will look at other factors before determining what mortgage loan you may be eligible for. These factors include: Amount of down payment paid towards the property; Debt-to-income ratio; History of saving money; Reasonable explanations for factors found within their credit history that has negatively impacted their credit score.
Cleaning Up Your Credit
Many people with low FICO scores will have invariably have a hard time qualifying for mortgages – the nation’s two largest mortgage providers, Fannie Mae and Freddie Mac, usually won’t accept borrowers who have FICO scores less than 620. Even if these people do qualify for a mortgage loan, the terms of the loan will undoubtedly include high interest rates to compensate lenders for taking such a risk. This type of mortgage may not be financially feasible for the borrower.
Fouled up FICO scores may sound like the nails in a financial coffin, but there are ways to improve badly damaged credit so don’t give up hope. But analogous to losing weight (without cosmetic surgery), there is no quick-fix method – it takes time and responsibility. Here are some tips to slowly build up your FICO score:
Pay your bills on time - Delinquent payments and collections can have a major negative impact on your score. If you have missed payments, get current and stay current. The longer you pay your bills on time, the better your score. If you are having trouble making ends meet, contact your creditors or see a legitimate credit counselor. If you begin managing your credit effectively and pay you bills on time, your FICO score will improve over time.
“Amounts Owed” Tips - Keep balances low on credit cards and other "revolving credit" since high outstanding balances can negatively impact your FICO score. The most effective way to improve your score in this area is by paying down your revolving credit. Owing the same amount, but having fewer open accounts, may even actually lower your score, so pay off debt rather than moving it around. Do not close unused credit cards as a short-term strategy to raise your score. Do not open a number of new credit cards that you don't need just to increase your available credit – this approach could backfire and even lower your FICO score.
“Length of Credit History” Tips - if you have been managing credit for a short time, do not open a lot of new accounts too rapidly since new accounts will lower your average account age. This will produce a larger effect on your FICO score particularly if you don’t have much other credit information. Additionally, rapid account buildup can look risky if you are a new credit user.
“Types of Credit Use” Tips – It is a myth that opening new credit accounts for a more diverse “credit mix” will raise you FICO score. It won’t. Although it is easier said then done, manage your credit cards responsibly. Having credit cards and installment loans will raise your FICO score (compared to someone with no credit cards), but if you’re not making your payments and letting your balance increase, that will decrease your FICO score. Note that closing a credit card account doesn't make it go away since it will show up on your credit report anyways.
Other “Credit Clean-up” Tips – Financial stability in a steady job is the best thing for improving your credit score as long as you’re able to budget wisely and pay of bills on time. Also, be sure to pay off any outstanding loans before applying for a new loan or mortgage. It may also be beneficial to seek out financial advise to more effectively manage your money.