Understanding Credit
Understanding Credit
One of the leading things that a lender considers when reviewing an application for a mortgage loan (or any loan for that matter) is the potential borrower's credit history. A person's credit history is nothing more than a record of their various loans and credit cards, the balances of any current loans or credit cards, a payment history, and any other pertinent financial information. The three main sources of information for a credit history are:
- Mortgage credit - home loans, home equity loans, etc.
- Consumer credit - installment credit (personal loans, student loans, etc.) and revolving credit (bank and merchant credit cards)
- Public records - previous bankruptcies, collections, foreclosures and judgements
Credit Score
Credit reporting companies use models that take into account an individual's credit history to generate a credit score. A credit score is nothing more than a numerical designation that gives an indication of the credit worthiness or credit risk of an individual. Lenders use credit scores to predict how likely an individual is to make their credit payments on time.
The most commonly used credit scoring model is the FICO model, which is named after the company that developed the model, Fair Isaac and Company. The resulting credit score is referred to as a FICO score. Every individual has three FICO scores, one from each of the three credit reporting companies: Experian, TransUnion, and Equifax. Lenders typically use the lowest reported credit score from the three companies when evaluating a loan application. When two individuals such as a husband and wife are applying for a mortgage, they take into account the lowest score of the six scores for the two people. Thus a spouse with a bad credit score can substantially impact a mortgage application.
What is Taken Into Account in a Credit Score
Many different factors are taken into account to develop the FICO score. These include:
- 35% of an individual's score is based on their payment history.
- 30% of an individual's score is based on their outstanding debt.
- 15% of an individual's score is based on the length of time that they have had credit.
- 10% of an individual's score is based on the number of credit inquiries on their credit report.
- 10% of an individual's score is based on the types of credit that they currently have.
How Credit Scores Impact Mortgage Interest Rates
Individuals with lower credit scores represent greater degrees of risk to lenders. As scores decline there is a greater risk of late payments, as well as default on the loan and possible foreclosure. This risk is represented in the interest rates that lenders charge individuals with lower credit scores. As an example, as of 12/12/2006, Fair Isaac Corporation reported the following differences in interest rates for credit score ranges:
| FICO Score | APR * |
|---|---|
| 760-850 | 5.742% |
| 700-759 | 5.964% |
| 660-699 | 6.248% |
| 620-659 | 7.058% |
| 580-619 | 8.271% |
| 500-579 | 9.169% |
* APR = annual percentage rate
Please note that interest rates change at least daily.
Credit Grade
Lenders use credit scores and credit history to provide a credit grade for individuals, on an A, B, C scale. The best grade is an A. An A grade borrower has a FICO score of 680 or higher, has low debt, has no late mortgage payments in the last 24 months, has no or only 1 late payment of 30 or 60 days, and has not declared bankruptcy in the last 2 to 10 years. Grades decline from A as debt rates increase, the number of late payments increase (especially mortgage late payments), the length of time of the late payment increases (60, or 90 days vs. 30), and recency of bankruptcy in the lower grades. In general the credit scores for the lower grades are:
- B - 620 FICO
- C - 580 FICO
- D - 550 FICO
- E - 520 and below
Each lender's grading criteria will vary and the FICO scores and other metrics for each given bracket will vary somewhat.
To Obtain a Credit Report
Congress recently passed legislation allowing individuals to get an annual credit report from each of the three credit bureaus (Experian, TransUnion, and Equifax) for free without any impact on their credit score for the inquiry. For an extra fee, they will also provide the individual with their credit score. To obtain free credit reports see: AnnualCreditReport.com.
