Amidst all the fear about falling home prices, tighter lending standards, the weak value of the dollar, a looming recession. . . While we can’t predict the future, one thing is certain: most mortgage lenders have tightened their lending standards.
One part of the build-up to the housing bust and the subprime mortgage mess was lenders’ lax standards. Requiring certain debt-to-income ratios, credit scores, and money in the bank fell by the wayside as – it seemed – everyone and their dog took out a loan.
But no more – and maybe the lending pendulum has swung in the opposite direction. Now lenders are being extra-cautious. They’re looking at income, credit scores, debt ratios, and home values – and checking them twice.
So if you’re looking to buy a home or refinance your mortgage, what will you answer when your lender asks: How’s your credit?
In this and my next two posts I’ll be writing about credit scores: today, I’ll talk about what your credit score is, why it matters, and how to check it. Then I’ll give you 8 steps to building good credit. Finally, I’ll show you how you can build up credit from scratch and fix errors on your report.
Credit score 101: what your credit score is, why it matters, and how to check it
Your credit report is generated by each of three national credit bureaus: Experian, Equifax, and TransUnion, based on information that your creditors report. When you run your credit report, you will see that it is a comprehensive list of your credit history.
Like the rest of us, lenders are always trying to find an easier, better way to do things. They wanted a more objective way to judge a person’s creditworthiness that didn’t require going through pages and pages of credit history. So in the 1980s, the three credit bureaus got together and jointly developed a method to generate a three-digit score, which is basically a summary of the pages of credit history information that’s in your credit report.
The score, called the FICO (Fair Isaac Corporation) score, is still the most popular tool lenders use to quickly judge your creditworthiness. Today, each credit bureau has its own version of the FICO score, but they’re all based on that original model that was developed in the 1980s.
That model considers five questions:
- Have you/do you pay your bills on time?
- What is the amount of your outstanding debt?
- How long is your credit history (how many years ago did you take out your first credit)?
- Have you applied for new credit recently?
- How many and what type of accounts do you have?
Each question is weighted differently – with your payment history and amount of outstanding debt the most heavily weighted.
When you run your credit reports and pull your credit score, most credit bureaus will show you how your credit score compares to other individuals’ scores. This is the most powerful feature of the credit score – the ability for lenders to compare prospective borrowers and assess probable default rates based on history.
Basically, what your credit score tells lenders is how likely you are to pay back the loan. For example, somewhere around 10% of all U.S. households have FICO scores less than 580, but those individuals account for nearly half of all loan defaults. What does that mean to a lender? It means that, statistically speaking, if you have a FICO score of 580, the chances that you will default on your loan are about 50%.
Not only does your credit score affect how likely you are to be approved for a loan, but it also affects the interest rates you will be eligible for. The higher your credit score, the lower the rate you will likely be offered.
How to check your credit reports and scores
Recent additions to the Fair Credit Reporting Act require each of the three credit bureaus to provide you with a copy of your credit report for free once every 12 months – at your request. To order your free report online, visit www.annualreport.com or call 1-877-322-8228. To order, you will need to provide your name, current address (and perhaps your past address, too), Social Security number, and birth date. You will also need to answer a “secret question” that only you would know – like whether or not you took out an auto loan for $275 in July, 2000.
You can also order your credit report more than once, for a fee, from any of the three credit bureaus. From them you can also get your credit score, as well as a host of other information about why your credit score is what it is and how you can improve it. To check out those products, visit the credit bureau’s websites or call:
- Equifax www.equifax.com
1-800-685-1111 - TransUnion www.transunion.com
1-800-888-4213 - Experian www.experian.com
1-888-397-3742
If you’d like more than your one-time-a-year free report, a simple credit report will typically cost you $9.50. A report with your credit score typically costs $14.95. The bureaus also offer a host of other products – from monthly reports and scores to 3-bureau reports and scores – also for a fee.
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