What is a Credit Score? - Innovative Mortgage Services, Inc.

What is a credit score?

Before deciding on what terms lenders will offer you on a loan (which they base on the "risk" to them), they want to know two things about you: your ability to pay back the loan, and your willingness to pay back the loan. For the first, they look at your income-to-debt obligation ratio. For your willingness to pay back the loan, they consult your credit score.

There are 3 agencies that maintain your credit records namely Equifax, TransUnion and Experian. They all have similar methods to calculate your credit scores. Experian uses an algorithm called FICO, TransUnion uses Empirica and Equifax uses BEACON. No one(except maybe the programmers that invented them) knows exactly how these algorithms work. The most common name when referring to a credit score is FICO which was developed by Fair Isaac & Company, Inc. (which was named after their inventor!). Your scores can be between 350 (high risk) and 850 (low risk). Each method will produce similar scores but sometimes there are big discrepancies between them. This happens because not all agencies keep your records updated when the information is reported, or sometimes your creditors(mortgage companies, auto loans, credit cards, etc.) don't send the information or just send the wrong information. When there are big discrepancies, you should inquire with the respective agency to correct the situation. Lenders utilize the middle score for qualification purposes. Sometimes only 2 scores are reported in which case the lower score is used. If only 1 score was reported then it's up to the lender to decide if they will accept it.

Credit scores only consider the information contained in your credit profile. They do not consider your income, savings, down payment amount, or demographic factors like gender, race, nationality or marital status. In fact, the fact they don't consider demographic factors is why they were invented in the first place. "Profiling" was as dirty a word when FICO scores were invented as it is now. Credit scoring was developed as a way to consider only what was relevant to somebody's willingness to repay a loan.

Past delinquencies, derogatory payment behavior, current debt level, length of credit history, types of credit and number of inquiries are all considered in credit scores. Your score considers both positive and negative information in your credit report. Late payments will lower your score, but establishing or reestablishing a good track record of making payments on time will raise your score.

The following factors affect your credit score:

Payment History – 35%. This is how well you have made your payments on all your accounts. If you have been more than 30, 60, 90 or more days late on any account it will show up here. Incidently, mortgage lates affect your scores the most.
Current Level Indebtedness – 30%. This means total liabilities or how much you owe vs. your credit limits. In other words if you have too many loans or have your credit cards maxed out it will have a negative impact.
Age of each account – 15%. Each account reported is called a tradeline. Ten year old tradelines are good, six month old ones aren't as good. In general the older the tradeline the better your scores. When you close accounts it actually decreases your score. That's why if you need to close an account for whatever reason, do it after closing on your mortgage. Even then try closing the newest one first, and do not close more than one every 6 months or so to minimize the impact on your score.
Types of accounts – 10%. Types of accounts can be installment loans such as student loans, auto loans, mortgages, etc. vs. revolving loans such as credit cards.
New Inquiries – 10%. This means that when someone other than you checks your credit, your scores decrease a little. If there are several inquiries for the same reason within a specific period of time, for instance, your are mortgage shopping, it only counts as one inquiry. However, if you shop for a new car, apply for a new credit card, or apply for a new mortgage, your score will take a hit.

When you obtain a copy of your credit report yourself, it does not count as an inquiry and therefore, your score will not be impacted. Anyone can and should obtain a copy of their credit report from all three agencies once a year by going to www.annualcreditreport.com and just follow the instructions. This WILL NOT give you the scores but at least you can check the tradelines for accuracy. This is the best way to correct errors prior to applying for a loan. If you want to obatin scores then you will have to pay a small fee.

Your credit report must contain at least one tradeline which has been open for six months or more, and at least one that has been updated in the past six months for you to get a credit score. This ensures that there is enough information in your report to generate an accurate score. One of the main advantages of FHA is that even if you don't have credit scores they will allow non-traditional credit reports. These are reports that can be obtained through private companies or the same lender evaluating the case, that creates scores based on other history such as your utilities bill, rent, insurance, student loan histories and others. If this is not a viable alternative or you just have a lot of negative information in your credit report, you may need to establish or cleanup your credit history in order to qualify for a mortgage. Read our blog for steps you can take to remediate this situation.