FICO SCORES ... How They're Arrived At ... How They're Affected by Short-Sales, Foreclosures, & Bankruptcies
Whether or not you are involved in a housing crisis of your own, this is great information for anyone who needs to understand how their credit score is arrived at...and that is all of us! Thank you Gene Mundt, an experienced mortgage banker (and one of my all-time favorite ActiveRainers) for this well written explanation!
It is pretty much understood, that if in foreclosure or going through a short-sale, credit scores are going to take a hit. What has not been clearly understood ... is just how much of a hit is felt? Until recently, there had not been much of a barometer or "method" known for calculating or determining how these delinquencies would affect a FICO score. Fair Isaac has recently revealed a little bit of information as to how they calculate that.
Explaining the five components that make up a FICO/Credit Score might prove helpful here. If they are known, the results of foreclosure, short-sale, and bankrurptcy will be better understood.
First and most importantly ... there's Payment History. Using this, FICO calculates future risk by studying past history of payments. This important portion of the calculation equals a full 35% of the total credit score. Credit card payments, student loans, mortgages, and the like are considered here. In a nutshell, make your payments in a timely and consistent fashion, this portion of your score will remain healthy.
A borrower's total outstanding amount of debt accounts for 30% of their score. There are sub-components found within this accounting of debt. A revolving line of credit will be weighed more heavily than an installment loan.
Example: Credit cards are revolving lines of credit. Credit cards have limits placed upon them. If you're balances on your cards are high and close to maxing the cards out ... this portion of your overall score suffers. This type of credit is taken into consideration more heavily than a car loan, which is an installment debt. In FICO's mind, a borrower with high credit card(s) debt is a poorer risk for future debt because they've shown tha
t they cannot handle their debt and spending in a responsible manner.
Next, making up 15% of the total credit score ... is the length of a borrower's credit history. Taken into consideration here is the length of time an account(s) has been open and the length of time since the account has most recently seen action. This is where it actually pays-off to have had some type of credit and not being paying by cash or check. The lengthier this history is, the more insight FICO has into the historical behavior of a borrower regarding how they handle debt.
(This also explains why a lender may ask a younger borrower for further documentation of finances/debt ... or even recommend that they open a credit card/line of credit. It gives them a "track record" for FICO to follow.)
Opening too many lines of credit can be damaging though. This remaining percentage of the components of your FICO score (10% and 10% each) are actually a mixture of new credit and the "mix" of your credit history.
To make the explanation of this easier, I've always likened a credit score to a "story". For some borrowers that story is a full-length movie ... for some it's a short skit. Open too many lines of credit and you run the risk of your "story" appearing like a long-running movie with a number of sequels ... movies that are filled with financial troubles, melodrama, and risk-taking. Simply put, FICO isn't going to like it. To get a five-star rating ... your story must flow smoothly, have perfect timing, and be low drama. Payments must have been made on time, never late ... and your credit card balances should be low.
It's important to point out here, that if you have a number of credit cards now ... do not think of closing or canceling the cards out. Pay down the balances, use them infrequently just to keep them active and then payoff the balance charged immediately. Closing the account out could actually harm your score, as it shortens your credit history.
For those that are presently facing the trauma of a short sale or foreclosure ... how does all of the above play-out on their scores? Where are those scores as they try to move forward financially?
Using the guidelines recently given by FICO, here is an estimate as to the impact o
f differing levels of delinquencies:
30 days late: 40 to 110 point drop
90 days late: 70 to 135 point drop
Foreclosure, short sale, deed-in-lieu: 85 to 160 point drop
Bankruptcy: 130 to 240 point drop
As you can see, as the delinquent payments become more serious, the point drop in score becomes more dramatic ... but for even one late payment the penalty in score is fairly severe. And unfortunately, the effects of late payments on credit scores is long-lasting.
It's easy to lose points ... hard to regain and re-establish them. It truthfully can take years. A homeowner that knows they are in credit jeopardy needs to communicate and work with their lender as quickly as possible. Forego the embarrassment and get help. If the problem has moved beyond that point, they then need to assess their financial damages and forget their credit scores. They cannot afford to let the scores rule
them and keep them from doing whatever they must for themselves and their families.
The sooner the decision is made to short-sale or foreclose, the sooner they can start to rebuild their lives, their financial health, and their new improved credit scores.
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