Buying a house can be a fun yet daunting task. Most of the anxiety is caused by the loan application process. Most people today can't afford to pay cash for their houses so the loan process is one we can't avoid. And the loan process itself has become a very complicated and drawn out process.
The two major unknowns of the loan process are whether you will get approved, and at what percentage rate. Both of these depend primarily on your credit. The better your credit, the better your chances for an approval at a low rate. But what exactly is good credit? What's the difference between A credit and A- credit or even B credit? Good question. Every bank has its own rules and definitions. That's where credit scores come in.
A General Guide to Credit Grades
|Bankruptcy/Foreclosure/Notice of Default|
|A+||None allowed in past 10 years|
|A-||Minimum 2 years with re-established credit|
|B||Minimum 2 years with some lates|
|C||Minimum 1 year|
|D||Discharged, 1 day out of|
The figures shown here are estimates. When trying to figure your credit grade, keep in mind the following principles:
- Other Things Being Equal - When your have derogatory credit, all of the other aspects of the loan need to be in order. Equity, stability, income, documentation, assets, etc. play a larger role in the approval decision.
- Worst Case Scenario - When determining your grade, various combinations are allowed, but the worst case will push your grade to a lower credit guide. Mortgage Lates and Bankruptcies are the most important.
- Going Once, Going Twice - Credit patterns are very important. A high number of recent inquiries and more than a few outstanding loans may signal a problem. A "willingness to pay" is important, thus late payments in the same time period is better than random lates as they signal an effort to pay even after falling behind.
The reasoning behind credit scores
Lenders needed a way to simplify the loan approval process. They wanted to make it more streamlined, (to reduce costs) and more impersonal (to avoid lawsuits). To solve this problem a company called Fair Isaac developed a credit risk model based on thousands of credit histories. The Fair Isaac Model called FICO was the first credit scoring system to hit the mortgage industry.
The FICO score is a number between 350 and 850 that tries to determine how much of a credit risk a consumer is. The higher the score, the less risky.
In the early 1990's, Fannie Mae, (FNMA) started requiring credit scores on all loans submitted to it for purchase. FNMA is the company that buys mortgage loans from lenders and banks. Therefore, most banks and mortgage companies need you to qualify for a FNMA loan so that they can sell your loan to FNMA. Ask your loan officer for more information about how the primary and secondary mortgage markets work.
FNMA decided that 620 was the cutoff credit score. They would not buy the loan of anyone with a score below 620. They consider that loan too risky. That loan then becomes harder to sell on the secondary market and this causes the rate for the borrower to go up.
What are your credit scores? Ask me and we will obtain your reports.
How the score is calculated
There are three major credit bureaus. Equifax, Experian, and Trans Union. Each of them has a file on you, meaning they each have a credit report available on you. Each of them also has different information on their reports about you. And each of them has their own credit score based on their information.
That means that you have 3 credit reports and 3 credit scores. Equifax uses a score called Beacon, TransUnion's is called Empirica, and Experian uses FICO.
Depending on what information is being reported by which bureau, your score could vary drastically from bureau to bureau. I have seen clients of mine have a score of 700 in one bureau and 595 in another bureau.
Lenders have gotten around this by saying that your middle score must be at least 620 to qualify for FNMA financing. For example, if your scores are 650, 635, and 619, you would qualify because your middle score of 635 is above 620.
How they come up with scores
The process of determining the scores is a very difficult mathematical calculation.
They take dozen of items into account. In fact, the bureaus do not even reveal the equation they use. They keep it very secret. Until very recently, no one except the bureaus themselves was even allowed to tell you what your score was. You could be sitting across the table from your mortgage broker and he was not allowed to tell you what your score was even if he had it in his hand! This has since changed, but the bureaus still want you to come to them first.
Basically, every piece of bad information on your report lowers your score. Major bad listings are collections, bankruptcies, consumer counseling, and foreclosure. Pretty bad listings are late payments. Bad listings are inquires, too high balances, and too many accounts. The computer then takes all this information and calculates a score to determine how risky you might be.
How to improve your score
Improving your credit score is the same as improving your credit. Here are some ways you can improve your credit score in a short amount of time. Before making any changes, I suggest a free consultation with me. Sometimes doing some of the things below can also hurt your credit. It depends on your specific situation.
- Stop applying for credit - no more inquires
- Pay down or payoff your credit card balances - keep balances at or below 30% of the limit.
- Consolidate student loans
- Consolidate as many other loans as you can
- Have any incorrect information on your credit reports removed
- Analyze if you should close accounts you do not use - it is ideal to have only 3 major trade lines
- Lower your payments on fixed payment loans like your house or car by refinancing.
If you have negative information on your report that you cannot remove, the bureaus say the best way to improve your score is to let some time go by. The older the negative information gets, the less important it becomes in the credit score mathematical equations.
The future of credit scoring
Credit scores are now being used in many more places then just the mortgage approval department. Credit card companies, banks, and even insurance companies accept or reject applications based on credit scores. Some people are starting to protest the use of credit scores in certain industries like insurance. But the benefits of credit scores outweigh the negatives, at least as far as lenders are concerned. So I see credit scores becoming more main stream. It will get to the point, if it is not already where applications will be accepted or rejected solely based on the credit score. And that is why it is so important that you make sure yours is as high as it can be.
At HOPE Lending we take pride in Trust that is Earned and Value you can Count On.