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You may have heard of credit scores and wonder what they are. This section explains credit scores and how they affect your ability to get a loan. Credit scores can also affect the interest rate you will have to pay on your loan. We also give advice on how you can improve your credit score.
When lenders evaluate your loan application, they use a process called underwriting. Underwriters judge your ability to repay your loan by evaluating your income and how stable your past earnings have been. This helps them to determine if you can afford the loan payments. They also judge your willingness to repay by looking at your past credit history. Generally speaking, someone who has made payments on time in the past will probably do so in the future.
Lenders want their evaluation to be as accurate, objective and consistent as possible. In an effort to achieve these goals, mortgage lenders use credit scores to help in the underwriting process. Credit scores rank individuals according to their credit history. Your score is based on your past payment history, the amount of credit you have outstanding, the amount of credit you have available, and other factors.
Most lenders use credit scores to help evaluate loan applications. However, a credit score is just one of many factors considered in the underwriting process. Even when a credit score is low, lenders try to find other factors that could overcome the negative credit issues and satisfy their underwriting criteria. Lenders look at the entire picture based on underwriting guidelines.
"FICO" scores are a type of credit score developed by Fair Isaac Company. FICO scores use credit bureau information to obtain a score which indicates how likely someone is to make their loan payments on time. FICO scores range from approximately 350 to 900. The higher the score the more likely someone is to make their payment. Similarly, the lower the score the more likely someone is to not make their payment.
A credit score is one factor in determining if you qualify for a loan and it may also be a factor in determining the price of your loan. The price of a loan is the interest rate and the points, charged by the lender and/or the mortgage broker. Credit scores are used in determining the price of a loan because they are believed to be a good indicator of a borrower’s ability and willingness to repay the loan.
Applicants with lower credit scores may pay higher prices for their loans because of the higher risk of default and loss. Mortgage Bankers that hold and service their own loans must cover the cost of loans which default, while investors who purchase loans are not willing to purchase higher risk loans without additional compensation. When mortgage loans are sold to investors the price increases as risk increases. Investors will pay a more favorable price for loans they feel have a low risk of default. Fannie Mae and Freddie Mac use credit scores as part of their analysis when purchasing loans for this very reason.
Each borrower’s credit score is a reflection of his or her unique credit profile. Because of this, it is difficult to quantify in advance exactly how each item in a credit history numerically impacts the credit score. For instance, it is impossible to determine how much your credit score will be affected if you pay off a delinquent account or cancel a credit card. We do know that there are things you can do to improve your credit profile. Some of the factors that may impact your credit score include:
- Making Timely Payments. Making your payments on time is the best way to increase your score. Delinquencies, foreclosures, bankruptcies and judgments will decrease your score.
- The Number of Trade Lines. The number of credit cards, lines of credit and other types of credit "trade lines" you have available will affect your score. If you have a lot of trade lines, this may decrease your score because of the risk that you might not be able to pay off all of your accounts, and this may affect your ability to pay off your mortgage loan. You may wish to consider canceling credit cards you do not use regularly or choosing 2-4 cards to use and canceling the rest. If you close or cancel an account voluntarily, it will not have a negative effect on your credit score. You may wish to reconsider accepting "pre-approved" offers for credit cards, or if you accept an offer, perhaps you should cancel another credit card. On the other hand, if you have no trade lines, this will likely decrease your score. Lenders generally want to see that you have some available credit and that you can handle your credit wisely.
- Avoid Unnecessarily High Credit Limits. Lenders also consider the amount of credit available to you (your credit limit) compared to your income when making underwriting decisions. Credit limits that are too high relative to your income can affect your score as much as having too many trade lines.
- How You Use Credit. The amount outstanding on each of your credit cards will also affect your score. In general, the lower the amount outstanding, the more likely it is that your score will be higher.
- Do Not Apply For Credit You Do Not Need. Whenever you apply for credit, the creditor will obtain a credit report from one or more of the three credit bureaus. Each credit inquiry will stay on your record and will affect your credit score. Even if you are turned down for the credit or change your mind and withdraw your application, your credit score will be affected. This is because each inquiry suggests that you are increasing the amount of credit available to you. However, don’t let the fear of inquiries stop you from shopping for the best deal when you need auto or home financing. The credit bureaus have recently recognized that borrowers may apply for credit at more than one place for the same transaction. The credit scoring companies generally consider all auto or mortgage loan inquiries received within a 14 day period as one inquiry so the additional inquiries will not affect your credit score. Lastly, if you order a copy of your credit report to verify accuracy, this will NOT show up as an inquiry on your record.
- Protect Your Personal Information A Social Security number is almost always required to run a credit report, so be certain your personal information will be protected when used for any credit inquiry. Always review an organization's privacy statement. Never give personal information to an organization you do not trust. Identity theft can destroy a perfect credit profile, and repairing it is time consuming and costly.
It is very important that you obtain a copy of your credit report from time to time to make certain the information is accurate. Inaccurate information, such as someone with a similar name as yours being reported on your credit report, can affect your credit score and you should immediately take steps to get it corrected.
Lenders, credit card issuers and other credit providers send regular reports about their accounts to the major credit bureaus. There are three major credit bureaus: Equifax, TransUnion, and Experian. Your credit report is compiled from these sources. You should contact each one since not all credit providers report to all of these bureaus. Also, if you have joint credit (or joint accounts), it is a good idea to get the credit report for each party of that account because there may be information on one report that does not appear on the other. You can reach the three credit bureaus at the following phone numbers and websites:
Equifax: 800-685-1111
TransUnion: 610-690-4909
Experian (TRW): 800-682-7654
In most cases, there is a small charge to obtain a copy of your credit report. The credit report will include instructions if you find errors on your credit report. Generally, you must write the credit bureau and advise them of the error or dispute. You may need to provide proof that the bill was paid or other information about the claim or dispute. The credit bureau will then contact the provider of credit who reported the information. The provider will then have 30 days to respond. If the provider of credit agrees that there is an error, it will instruct the credit bureau to delete the item from your credit report.
You should allow at least 30 days after you have notified a credit bureau of an error in your credit report for that error to be investigated and resolved. It may take longer depending upon the nature of the error and investigation to be done.
To learn more about credit scores and solving credit problems, we have listed below some additional reading.
Fair, Isaac and Co., Inc.; 120 North Redwood Dr., San Rafael, CA 94903; 415-472-2211
http://www.fairisaac.com
Video: Credit Bureau Scores in Mortgage Lending
Analyzing A Credit Report: Fact * Fallacies
Answers to Your Questions About Credit Scoring: A Consumer’s Guide to Scoring
Credit Bureau Scores in Mortgage Lending
Board of Governors of the Federal Reserve System; Washington D.C.
Bulletin, Volume 82, Number 7, July 1996 "Credit Risk, Credit Scoring and the Performance of Home Mortgages"
Freddie Mac; 8200 Jones Branch Dr., McLean VA 22102; 800-FREDDIE
http://www.freddiemac.com
Credit Scores: A Win/Win/Win Approach for Homebuyers, Lenders and Investors
Automated Underwriting: Making Mortgage Lending Simpler and Fairer for America’s Families
Office of the Comptroller of the Currency; Washington D.C.
Bulletin 97-24: "Credit Scoring Models"
Associated Credit Bureaus, Inc. 1090 Vermont Ave. N.W., Washington D.C.
"What You Should Know About Your Credit Record"
"Fix Your Own Credit Problems and Save Money"
"Code of Ethics in Credit Reporting"
"Solving Credit Problems"
"Building a Better Credit Record"
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