Updated: Feb 11
My father used to say, "if you're ever arrested and put in jail don't call me. If you ever can't pay your credit card bills call me. I'd rather you rot in jail than ruin your credit." He was kidding, I think. Or maybe not. Either way it made a lasting impression. What he meant was that any marks against your credit will stick with you for a long time and at some point you'll need to borrow money to make a major purchase. If your credit history isn’t good enough you won't be eligible to make the important buys that will affect your life and your family when you need to. For most people, at the top of the list of biggest purchases you'll ever make, and therefore the most likely scenario you'll need to borrow money, is when you buy a house. There are several elements a lender will consider before extending a mortgage. This article will focus on a three-digit number that mortgage lenders use to help evaluate your credit history called a FICO score. It may come into play even earlier in the house hunting journey if you get, or are asked to get, a mortgage pre-approval as some home seller’s may want to know you’re a qualified buyer before they’ll show you a house. Why is your FICO score important? Because mortgage companies have no way to predict if you’ll pay your bills in the future but they can look at your past credit history to help them understand the risk of lending you money. Basically, are you a safe or risky bet? The safer a bet you are, i.e., the more likely you are to repay the money, the more likely you are to get the loan and at a lower interest rate. Conversely, the riskier a bet you are the less likely you are to get the mortgage and if they do lend you the money they will want to be compensated for their risk in the form of a higher interest rate.The most important thing is qualifying for the loan but but a close second is getting as low a rate as possible. Being lent money at a rate of a percentage points higher than what you could’ve gotten really adds up over a normal thirty year home mortgage term. For instance if the interest rate you are offered is 4.5% because your credit has been dinged over a few late credit card payments instead of 3.9% it may cost you tens of thousands of dollars. A $300,000 loan at the interest rate of 4.5% will cost you $547,220 over a 30 year term. The $300,000 at 3.9% rate will cost $509,402. That’s almost a $40,000 difference.
What is a FICO Score?
The FICO score stands for Fair Isaac Corporation and your score is based on information collected by three major credit bureaus. Equifax, Experian, and TransUnion. How your FICO score is calculated, what information is considered and not considered, and what can lower your credit score or raise it will be discussed in this article. Let's take a look.
There's five major factors that make up your FICO score. Here they are listed in order of importance:
35% is your payment history
30% is the amount of money you currently owe
15% is the length of your credit history
10% new credit and recently opened accounts
10% the types of credit in use
FICO ignores factors such as:
Your race, color, religion, national origin, gender, or marital status
Your salary, occupation, title, employer, date employed, or employment history
Where you live
The interest rates on your other forms of credit
Whether you pay child support or alimony
Promotional inquiries from lenders without your knowledge, and employment inquiries
If you’ve received credit counseling.
What Lowers A Credit Score? .
Late or missed payments
35% of your FICO score is based on your payment history on accounts such as credit cards, retail accounts, installment loans, mortgage, and certain public records like liens, foreclosures, and bankruptcies. Also, the number of past due items on file, and how long those accounts are past due. So considering our example of how much a few percentage point difference in interest rates you get and how late or missed payments is one of the biggest deciding factors, say you buy a pair of jeans on a credit card and don’t pay the bill. That could become a $40,000 pair of jeans. Or a $40,000 slice of pizza.
How much of your credit is in use:
30% of the FICO score is based on how much credit is available to you and how much is in use . For example, if you’ve charged $19,000 on your credit cards out of $20,000 that’s available to you a lender may be worried about your financial situation.You may seem overextended and they could become concerned about you repaying your debts in the future. Lenders call this your credit utilization ratio. If you can pay off some of your debt your score will go up.
A short credit history, or none at all
Your age doesn’t determine your credit score but the age of your credit history does. 15% of your FICO score is based on the length of your credit history, including the amount of time since the various accounts were opened and used. Patience is a virtue so if you're young you may not be offered much credit because you don’t have much credit history but if you keep on top of things, pay your bills on time you will be offered more credit and eventually, over time, you'll reap the rewards later. Building credit takes a long time but ruining it can happen very fast though so be careful with any additional credit you receive.
Too many requests for new lines of credit
Ever get mail or email that says you're pre approved for a credit line. You won't be penalized for that. However, getting new credit cards and car loans will lower your score. So you may want to wait before taking out a car loan or a new credit card just prior to applying for a home loan because your score negatively will be negatively impacted when you need it the most. The 10% of your FICO score that is based not only on new credit accounts, but also the percentage of new accounts compared with the total number of accounts, the number of recent credit inquiries other than consumer and promotional inquiries, and how long it's been since new accounts were opened or credit inquiries were made.
Can you have too few types of credit
Well, there's a fine line. You'll be penalized for too little and too much credit. 10% of your FICO score is based on the types of credit you use, such as credit cards, a mortgage, an auto loan, and so forth. Believe it or not having only one type of credit can have a negative impact on your score. Having different credit types improves your score because you seem like an experienced borrower. Basically, you’ve borrowed money in the past and you understand how to balance how much money is coming in and how much is going out.
How can you help yourself?
We all get busy and forget to pay a credit card or utility bill from time to time. Not because you don’t have the money but because you forget. You can set up automatic payments, subscribe to reminders, set alarms on your phone, or put post-its on your fridge. Whatever It takes to remember. People that don’t know you are lending you money. All they have to look at is your history. It's not a perfect system and to be perfectly honest it's definitely skewed towards the lender but that's the game. They make the rules. At least you know what they are when you get onto the game.
Can You Raise a Credit Score?
Yes but beware of anyone or any companies that say they can do it overnight.
Here’s some tips:
Check your credit report. You get one free report a year from each of the three major credit bureaus. Equifax, Experian, and TransUnion. Use them. Even if you don’t plan on applying for a mortgage anytime soon see if there are debts you don’t even know you have. Maybe one of your creditors accidentally entered you as paying late when it was someone who had a similar social security number. Also, identity theft is real. Someone could have opened credit cards in your name. That can be remedied but it's a long and hard journey you don’t want to take after you've found your dream home and are applying for a mortgage. Under the Fair Credit Reporting Act, you have the right to an accurate credit report. This allows you to dispute credit report errors by writing to the relevant credit bureau, which must investigate the dispute within 30 days.
Lower the amount of debt you owe by paying as much as you can pay off and don't just move it around by paying off one credit card with another credit card. That may get one company your back for a little while or lower the interest rate you pay on the debt but that isn’t going to change your overall credit score because the amount you owe is still the same and that’s what FICO is looking at.
You can request a free copy of your credit report from each of three major credit reporting agencies – Equifax®, Experian®, and TransUnion® – once each year at AnnualCreditReport.com or call toll-free 1-877-322-8228. You’re also entitled to see your credit report within 60 days of being denied credit, or if you are on welfare, unemployed, or your report is inaccurate. Review these reports carefully, as each one may contain inaccuracies. If you spot an error, request a dispute form from the agency within 30 days of receiving your report.
Building credit is a long hard process. It takes years to establish good credit but it can disappear overnight with some bad breaks. Handle it with care and when you need it you’ll be rewarded with the ability to make the big purchases in life. You’ll be glad you did.