Home Buyer's Guide to
Credit Scoring
from Universal
Home Mortgage Inc.
INTRODUCTION
The subject of credit scoring has become an increasingly hot topic,
and for good reason. For many years, the general public only associated
the concept of credit scoring with the need to purchase high ticket
items such as a new car or a home. Today, credit scoring goes much further.
Your credit score can affect your ability to get a good rate on commodities
such as car insurance, cell phones, or even determine whether or not
you get the job that you want. Indeed, the financial snapshot provided
by the credit score has also become a gauge for many employers, especially
those who seek to place employees in a position of financial responsibility.
The History of Credit Scoring
The credit score system used today has evolved since the 1960s. It was
originally designed to provide lenders with financial profiles on consumers
who wished to borrow money. The lenders' biggest concern was whether
or not an individual had the ability to repay a loan, and establish
what percentage of risk might be involved.
Congress passed the Fair Credit Reporting Act in 1971 to establish guidelines
for fair practices in regard to the use of credit scoring. This law
was designed to promote accuracy in reporting and protect the privacy
of consumers. In light of the increased use of credit scoring and a
growing fear of identity theft, recent legislation has been passed to
further protect Americans and improve consumer awareness.
The Fair and Accurate Credit Transactions Act of 2003 (sometimes referred
to as The FACT ACT or FACTA) was signed by President George W. Bush
on December 4, 2003. This amends the Fair Credit Reporting Act, and
provides each American the ability to obtain one free credit report
every 12 months from each of the three main credit reporting agencies
(CRAs); Equifax, Experian and TransUnion. Those bureaus have created
a central web site, www.annualcreditreport.com, to accommodate Americans
who wish to obtain copies of their credit report. Phase in of access
to free credit reports from West Coast to East Coast nationwide will
be complete as of September 1, 2005. See www.annualcreditreport.com
for a zoning map.
WHY YOUR
CREDIT SCORE IS SO IMPORTANT
The credit scoring model seeks to quantify the likelihood of a consumer
to pay off debt without being more than 90 days late at any time in
the future. Credit scores can range between a low score of 300 and a
high score of 900. Most consumers have credit scores ranging between
400 and 800. The higher the score, the better it is for the consumer,
because a high credit score translates into a low interest rate. This
can save literally thousands of dollars in financing fees over the life
of the loan.
Only one out of 1,300 people in the United States have a credit score
above 800. These are people with a stellar credit rating that get the
best interest rates. On the other hand, one out of every eight prospective
home buyers is faced with the possibility that they may not qualify
for the home loan they want because they have a score falling between
500 and 600.
The Five Factors of Credit Scoring
Credit scores are comprised of five factors. Points are awarded for
each component, and a high score is most favorable. The factors are
listed below in order of importance.
Payment History - 35% Impact
Paying debt on time and in full has the greatest positive impact on
your credit score. Late payments, judgments and charge offs all have
a negative impact. Missing a high payment will have a more severe impact
than missing a low payment, and delinquencies that have occurred in
the last two years carry more weight than older items.
Outstanding Credit Balances - 30% Impact
This factor marks the ratio between the outstanding balance and available
credit. Ideally, the consumer should make an effort to keep balances
as close to zero as possible, and at least 10% below the available credit
limits. (A balance 30% below the available credit limit is better.)
Credit History - 15% Impact
This portion of the credit score indicates the length of time since
a particular credit line was established. A seasoned borrower will always
be stronger in this area.
Type Of Credit - 10% Impact
A mix of auto loans, credit cards and mortgages is more positive than
a concentration of debt from credit cards only.
Inquiries - 10% Impact
This percentage of the credit score quantifies the number of inquiries
made on a consumer's credit within a six month period. Each hard inquiry
can cost from two to 25 points on a credit score, but the maximum number
of inquiries that will reduce the score is ten. In other words, 11 or
more inquiries within a six month period will have no further impact
on the borrower's credit score. Note that if you run a credit report
on yourself, it will have no affect on your score.
Remember that the credit score is a computerized calculation. Personal
factors are not taken into consideration when a credit report is generated.
It is merely a snapshot of today's credit profile for any given borrower,
and it can fluctuate dramatically within the course of a week.
HOW DOES THE UNDERWRITER VIEW
A SCORE?
If you are considering a home purchase, it is in your best interest
to make every effort to increase your credit score, especially if you
know you have issues you should be dealing with. It is often the case
that people are not aware of bad marks on their credit record until
they apply for financing for a major purchase, such as a home.
As part of the loan process, we run a credit report for you. But you
can take advantage of the opportunity to get a free credit report from
each of the three main CRAs: Equifax, Experian and TransUnion. As a
sidebar, you can choose to get the free report from all three bureaus
at the same time, so you are aware of what information each bureau has
collected. Another option is to pull your credit report from one agency,
and reserve the right to get your free reports from the other two CRAs
as you work on improving your credit standing.
We believe it is best to have the full overview up front. Different
CRAs have different methods of calculating these scores, and may also
have different information contained within their findings. Consider
the adage, “Why jump over nickels to pick up pennies?” If
additional reports are needed within a 12-month period from any of the
three CRAs, the cost is extremely minimal compared to the potential
savings that can be realized by an improved credit score, and if you
run a credit report on yourself it will not affect your own score as
an inquiry.
The underwriter who is making the decision as to whether or not you
should get the loan you are asking for will generally look at the scores
generated from all three CRAs. Typically, the score will not be the
same from all three reports, and the underwriter will consider the middle
score as a barometer.
DISPUTING ERRORS ON THE CREDIT
REPORT
If you are in the process of reviewing your credit reports, the first
thing to do is make sure that the information contained within the reports
is correct. In June 2004, The U.S. Public Interest Research Group published
the results of a survey it conducted involving 200 adults in 30 states
to test the validity of credit reporting. Their findings were as follows:
Twenty five percent (25%) of the credit reports contained errors serious
enough to result in the denial of credit;
Seventy nine percent (79%) of the credit reports contained mistakes
of some kind;
Fifty four percent (54%) of the credit reports contained personal demographic
information that was misspelled, long outdated, belonged to a stranger,
or was otherwise incorrect;
Thirty percent (30%) of the credit reports contained credit accounts
that had been closed by the consumer but incorrectly remained listed
as open.
(SOURCE: U.S. Public Interest Group Research; One In Four Credit Reports
Contains Errors Serious Enough To Wreak Havoc For Consumers, US PIRG
Press release, 06/17/04
http://uspirg.org/uspirgnewsroom.asp?id2=13650&id3=USPIRGnewsroom)
If you find that you have errors on your credit report, follow this
procedure to correct those errors.
Make a copy of the report and circle the items you are questioning.
Keep your original copy for your own records.
Prepare a letter to the CRA that provided you with the report in question,
and request to have the erroneous item(s) removed. If you have proof
of payment for an item in question, include a copy of that documentation.
Prepare a letter to the creditor reporting the problem, especially if
you feel you are a victim of fraud or identity theft. Inform the creditor
that you are disputing an error reported to the CRA, state why the claim
is inaccurate, and include any relevant documentation to prove your
point.
Send your correspondence via certified mail. You should receive a response
from the CRA within 30 to 45 days. If the error has been corrected,
they will send you a new copy of your credit report at no charge to
show you that the item has been removed. They will also send a corrected
report to any entity that received a report that contained errors within
the last six months. If you cannot have a disputed item removed, you
have the right to include your side of the story on the credit report.
Your statement should be a concise explanation (100 words or less) as
to why you are challenging the item in question. From that point on,
this notation will be included in your credit report as long as the
item in question remains on your report.
DEALING WITH CREDIT CHALLENGES
What If I Have No Credit?
A borrower will sometimes not have enough credit references to obtain
the loan they wish to secure. In this case, start by opening small lines
of credit that report to one of the three major CRAs, and make purchases
that can be paid off easily. If you do not already have a checking or
savings account, open one. Your bank or credit union may be able to
provide you with a credit card account once you have established a history
with them as a customer. Ask your family or spouse to add you to their
credit card account. By adding your name to an established line of credit,
you can ride on their coattails, so to speak, and gain points by using
that person's credit history.
It is also wise to start saving money for the down payment on your home.
The lender will look at your application more favorably when you are
able to come to the table with a 20% down payment. Bear in mind, there
are certain loan programs available that permit a percentage of gift
money for down payment, which can come from a relative, or even the
person selling the home.
Improving Your Credit Score
If your credit score is in need of improvement in order to secure
financing, here are a few tips to help bring your score up:
Example 1: Distribute debt from revolving credit.
Our borrower, Mr. Jones, has a credit score of 664. He has five credit
cards, but his Visa account is almost maxed out. His other four credit
cards have relatively low balances. Mr. Jones moves the part of the
debt from the Visa account to the other major credit card accounts,
thus distributing the debt more evenly over the five cards. This changes
the ratio of debt to available credit (which has a 30% impact on the
overall credit score), and Mr. Jones successfully raises his credit
score by 20 points with very little effort.
Example 2: Transfer outstanding balances to new accounts.
Our borrower, Mr. Smith, has only two credit cards, but both are pushing
the limit of available credit. Mr. Smith opens two new credit card accounts,
each with a credit limit of $5,000. He transfers part of his existing
balances to the new accounts. While he has acquired two new cards that
have no established history, the greater impact is the change in the
ratio of debt to available credit. Ultimately, experts say that it is
best to have two to five credit cards, and no more than that. You should
keep your balances as low as possible. If you have a credit account
with a zero balance, do not close the account. Instead, make a small
purchase so the card shows up as an active account on your credit report,
and you will be awarded points for your long term credit history.
These are just a few tips to consider as you seek to obtain mortgage
financing. But you should always know that as your loan originator,
my job is just beginning when you close your loan with me.
As soon as you begin to make mortgage payments on time and in full,
your credit standing will begin to improve. My team and I will continue
to monitor rates on your behalf and alert you to the opportunity to
refinance into a loan program with a lower interest rate as soon as
possible. Our long term goal is to help you build a strong financial
future.
DO'S AND DON'TS DURING THE LOAN
PROCESS
When you fill out a credit application, we run a credit report for the
underwriter. Each lender and each loan program has different guidelines
they must follow. You should not do anything that will have an adverse
affect on your credit score while your loan is in process. We know it's
tempting... If you're moving into a new home, you might be thinking
about purchasing new appliances or furniture, but this is really not
the right time to go shopping with your credit cards. You'll want to
remain in a stable position until the loan closes and give us the opportunity
to help you lock in the best interest rate we can possibly get for you.
Here is a handy list of do's and don'ts that you should adhere to after
your loan application has been submitted to the lender.*
Don't Apply For New Credit Of Any Kind
If you receive invitations to apply for new lines of credit, don't respond.
If you do, that company will pull your credit report and this will have
an adverse effect on your credit score. Likewise, don't establish new
lines of credit for furniture, appliances, computers, etc.
Don't Pay Off Collections Or Charge-Offs
Once your loan application has been submitted, don't pay off collections
unless the lender specifically asks you to in order to secure the loan.
Generally, paying off old collections causes a drop in the credit score.
The lender is only looking at the last two years of activity.
Don't Close Credit Card Accounts
If you close a credit card account, it can affect your ratio of debt
to available credit which has a 30% impact on your credit score. If
you really want to close an account, do it after you close your mortgage
loan.
Don't Max Out Or Over Charge Existing Credit Cards
Running up your credit cards is the fastest way to bring your score
down, and it could drop up to 100 points overnight. Once you are engaged
in the loan process, try to keep your credit cards below 30% of the
available credit limit.
Don't Consolidate Debt To One Or Two Cards
Once again, we don't want you to change your ratio of debt to available
credit. Likewise, you want to keep beneficial credit history on the
books.
Don't Raise Red Flags To The Underwriter
Don't co-sign on another person's loan, or change your name and address.
The less activity that occurs while your loan is in process, the better
it is for you.
Do Join A Credit Watch Program
Your bank, credit union or credit card company may be able to provide
you with a free credit watch program that can alert you to any changes
in your credit report. This can be a safeguard to help you intervene
before the underwriter sees a problem.
Do Stay Current On Existing Accounts
Late payments on your existing mortgage, car payment, or anything else
that can be reported to a CRA can cost you dearly. One 30-day late payment
can cost anywhere from 30 to 75 points on your credit score.
Do Continue To Use Your Credit As You Normally Would
Red flags are easily raised within the scoring system. If it appears
you are diverting from your normal spending patterns, it could cause
your score to go down. For example, if you've had a monthly service
for Internet access billed to the same credit card for the past three
years, there's really no reason to drop it now. Again, make your changes
after the loan funds.
Do Call Your Loan Consultant
If you receive notification from a collection agency or creditor that
could potentially have an adverse affect on your credit score, call
us so we can try to direct you to the right resources and prevent any
derogatory reporting to credit bureaus.
*SOURCE: Based on The Top 10 Credit Do's and Don'ts During the Loan
Process, provided by Credit Resource Corp. http://www.creditresourcecorp.com
CREDIT REMEDIATION
If you feel you would prefer to work with a credit repair service rather
than try to tackle credit repair issues on your own, please give us
a call so we can help you sort through your options. We will do our
best to refer you to a reputable credit remediation service and guide
you in the right direction once we have the opportunity to review your
credit report with you.
The Federal Trade Commission (FTC) regulates credit repair services
and provides free information to help consumers spot, stop and avoid
doing business with credit repair companies that are not reputable.
Their web site is located at http://www.ftc.gov.
You can also write to the FTC to request a copy of their free brochure
titled Credit Repair: Self Help May Be Best, which includes information
about credit clinics. The address to write to is:
Federal Trade Commission
Sixth and Pennsylvania Avenues, NW
Washington, DC 20004
If you have any complaints regarding your credit report or credit remediation
services that you wish to report to the FTC, contact them at:
Federal Trade Commission
Consumer Response Center, Room 130
600 Pennsylvania Avenue, NW
Washington, DC 20580
