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The History
of Credit Scoring
What is a Credit Score?
Why Your Credit Score is So Important
The Five Factors of Credit Scoring
Disputing Errors On the Credit Report
Dealing with Credit Challenges
Dos and Don’ts During the Loan Process
What if I Have No Credit?
The History of Credit Scoring
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 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 amended the Fair Credit Reporting
Act, enabling each American 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.
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What is a Credit Score?
A credit score is a number that represents your calculated measure
of credit risk. Your credit score is the result of a complex mathematical
formula that takes into account numerous factors in your credit
history. Put simply, your credit report is scored against millions
of other people's credit reports, generating your consumer credit
score. Your credit score is very important because it can determine
your financial future. More specifically, your credit rating can
affect whether or not you can obtain
- A mortgage
- A car loan
- A credit card
- A school loan
A company may also use your credit score to calculate the rate
you get for a loan; the lower your consumer credit score, the higher
the interest rate you'll be charged. So over time, a good credit
score can save you lots of money. Companies look at your credit
score report as a prediction of how likely you are to make your
payments and make them on time.
In addition, potential employers may do a credit check for employment
to determine whether you're financially responsible. And landlords
often do a credit check for renters.
It’s important to know that you may get a different score
than one pulled by a company who is checking your credit score,
because the information in your credit file is constantly changing.
The credit score you get this week may not be the same score a
company would get from the credit reporting company the next week.
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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 850. 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.
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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 definitely
below 30% of the available credit limit when trying to purchase
a home.
- 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. What most borrowers
do not know is that it also
takes into consideration variations in the personal demographic
information that is being reported about
the person to the three credit bureaus. So if you have too many
names reporting, AKAs, you are losing points. If you have
too many variations in your addresses being reported, you are losing points.
The logic behind this is that the credit reporting system feels that
if you are a good credit manager, you will check your credit every
six months. If there are some errors on the credit report, a person has to
clean them up.
- 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 effect 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.
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Disputing Errors On the Credit Report
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 item(s) you are questioning.
Keep your original copy for your own records.
- Prepare a letter
to the CRA (Credit Reporting Agency) 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 fresh 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.
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Dealing with Credit Challenges
Unfortunately, a person with a bad credit score is often in this
position because he or she lacks the discipline to pay bills
on time. Of course, there are exceptions where unforeseen circumstances
come into play, such as health complications, or loss of employment.
There are a few things that may be able to bring your score up
so that you can secure a better interest rate on your mortgage
loan.
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
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 three 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.
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Dos 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 effect 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 dos 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.
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What if I Have No Credit?
On occasion, a borrower will not have enough credit references
to obtain the loan they wish to secure. If this is the case for
you, 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.
If you don't have a credit card, DO get a secured card immediately.
This is a great way to rebuild or establish credit quickly.
Because this account is secured by funds that you deposit (typically
between $100 and $400) you're not seen as a great risk to the card
issuer because of your initial investment. Again, use this card
strategically to build a strong credit history. Pay your bill on
time every month, and it won't be long before you qualify for an
unsecured credit account. Talk to your mortgage professional about
which cards to apply for.
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