This post is part of our Financing 101 series. Click here for more from Financing 101.
The three basic ingredients for a successful real estate loan approval are sufficient income, available funds, and good credit. Not perfect credit, but good credit. And the primary indicator of good credit is your credit score. Lenders can raise or lower the interest rate or even deny your loan application altogether based on this mysterious number.
Lenders use your credit score that to determine the likelihood that you will pay your mortgage on time and not default, leaving them stuck with the property. They also use it to determine what rate or loan program to offer you.
What is a Credit Score?
In the past, lenders evaluated credit reports manually. Line by line, they looked at outstanding loan amounts, minimum payments, and negative information such as late payments, collection accounts or bankruptcies. Today, however, lenders only review credit reports manually if there are problems. Otherwise, they use a qualifying credit score.
Lenders commonly refer to credit scores as FICO scores, named for Fair, Isaac, and Company, which invented the algorithm that computes scores. These scores range from 300 to 850. The lower the number, the worse the score, and the greater likelihood of default in a lender’s eyes.
When lenders request a Residential Mortgage Credit Report (RMCR)—a credit report specifically designed for the mortgage industry—they also request a FICO score from each of the three main credit bureaus: Equifax, Experian and TransUnion. Each bureau uses FICO to report a borrower’s score based upon information provided by credit-extending businesses.
Because businesses can report credit patterns at different times to different bureaus, the three credit scores will typically be similar, yet not exactly alike. Mortgage lenders use the middle of the three scores when considering a mortgage application. If there are two borrowers on the application, the lender uses the lowest middle score of the two.
Your credit score reflects five factors:
Payment History
Your payment history is the single most important category in your FICO score. Accounting for 35% percent of your total score, it reflects your reliability in meeting your credit obligations. Note that if a payment is due on the 10th, but not received until the 11th, your FICO score won’t be affected. It’s when your payment becomes 30, 60 and 90 days past due that you’ll run into trouble.
Prior to credit scoring, you had to explain any derogatory information in your credit report in a letter. If, for example, you made a car payment 40 days late, you’d give the lender a letter stating something to the effect of, “I was late because I thought I had made two payments at once.” Today, lenders care less about the explanation and more about the score.
Available Credit
The next most important factor in your credit score is your available credit, or credit utilization. Counting for 30% of your score, this metric is calculated by dividing your balances by your limits. Scores increase when your balances reach approximately 30% of your available credit. This magical number indicates that you borrow wisely, pay on time, and don’t abuse credit. If you have a limit of $10,000 on a credit card and your balance is $3,000, your credit scores will march upwards. If you’re also making timely payments, your credit scores rise even faster.
Yet as loan balances approach your credit limit, scores begin to fall. The credit bureaus see a balance that’s close to a credit limit as a warning sign that the borrower may be going through tough financial times. Say you carry a balance of $7,500 over a few months on your $10,000 limit. That will erase any gains you’ve made, and your scores will begin to drop as you have less and less credit available. Worse, if your balance exceeds your available credit, credit scores will be hit hard.
Should you close down accounts with a zero balance? Not necessarily. Say you have three credit cards, each with a $5,000 credit limit, for a total of $15,000. Each card has a balance of $1,500, right at the 30% mark of $4,500. Then one of the cards offers a 0% interest rate for 12 months for balance transfers. You transfer two balances to that card and close the other two. What just happened? You got a great rate, but now you have a $5,000 credit limit and a $4,500 balance, or 90% of available credit. Even though the move may be prudent, your scores might be hurt.
Just as keeping a 30% balance and making timely payments positively affects FICO scores, the combination of high loan balances and late payments hurts your scores. When these two categories represent nearly two-thirds of your total score, it’s easy to see how keeping an eye on them if critical is you’re trying to establish and maintain good credit.
Length of Credit History
This category reports how long you’ve been using credit, so keep old accounts open and in good standing. The longer you’ve had credit, the better your score will be, because you’ve demonstrated good payment patterns over a period of time. This factor accounts for 15% of your score.
Types of Credit
Representing 10% of the total FICO score, the types of credit you use can alter your score. A timely mortgage payment history will have a greater positive impact than a car payment. Again, that’s because the lender is using the property you want to buy as collateral, but doesn’t want to own it, so is assessing the likelihood that you will pay your mortgage.
New Inquiries
Mortgage loan officers often tell clients not to apply for any new credit while their loan application is being processed. True, they don’t want you to take on more debt, but they also know that your credit score can fall each time you apply for credit and a potential creditor reviews your report. A single application for a department store card won’t have much of an impact, but multiple requests for different loans certainly will.
How to Improve Your Score
The most effective way to improve or repair your credit score is to concentrate on your payment history and the amount of available credit you have. If you’re applying for a real estate investment loan and find that your score is just below the requirement, keep your payments on time and pay your balances to 30% of available credit. In a few months, you should see better scores.
