Credit is an important factor in all major financial decisions—student loans, financing a car, and certainly buying a house. It can and will affect what you can do, what you can’t do, and how much it’s going to cost. Your credit is your financial track record, and your credit worthiness is reflected in your 3-digit credit score. This score is how financial institutions predict your risk: how likely are you to make your payments on time? How likely are you to make your payments at all? Etc. Let’s break this down. Here are the credit score basics we’ll address:
• What kind of information makes up your credit score
• How your credit score affects mortgages specifically
• How you can improve your credit score
Your credit score is calculated (or scored) through the Fair Isaac Corporation (FICO) method, and is reported by the three major credit bureaus: Experian, TransUnion, and Equifax. Think of your credit score as a financial grade much like a subject in school. The credit bureaus create a percentage of various financial habits, weighing each according to their determined importance, and averaging it all together in one final score. They consider things like your payment history, outstanding debt ratio, the age of your accounts, and the type of accounts you have. The number will range from 300-850—the higher the score, the better your credit.
When you apply for a mortgage loan, lenders will pull your credit score from the three main credit bureaus. Because each credit bureau scores a little differently, lenders will take your “mid” score. For example: Equifax scores 710, TransUnion scores 720, and Experian scores 680 – the Equifax 710 score is the qualifying “mid” score because it falls between the other two. Why is your credit score important for your mortgage loan? Well, besides the fact that bad scores can lead to a complete denial of a loan, the better your score, the better your rate. Having a better rate can save you thousands of dollars long-term because you pay less interest on your loan. The difference between an 8% and a 5% loan is thousands of dollars—for instance, on a $250,000 loan it’s a difference of $7,500. That’s a hefty chunk of change to pay over a credit score that can be improved!
Yes, you can improve your credit score. There are three main ways to do this:
- Paying your bills on time- this factor makes up 35% of your credit score. Missing any payments can significantly reduce your score and become detrimental to your borrowing ability.
- Paying down credit balances – credit bureaus reward those who maintain less than 30% of their limits, and your score will improve by paying the balance altogether.
- Keeping your old, paid off accounts open – even if you no longer use the account, don’t close it. Closing these accounts reduces your total credit limit bringing your outstanding balances to a higher percentage thus lowering your credit score. If these are old accounts, they will reflect a longer credit history.
Everyone is legally able to obtain a copy of his or her credit report from all three credit bureaus once a year for free. It is a good idea to get the free report and check for any discrepancies that could be affecting your credit score.
Your credit score and financial history are greatly influential in determining your borrowing ability. It is important to understand how your financial history is scored, how it affects your ability to borrow, and how you can improve your credit score. By following these credit score basics, you should be on your way to preparing yourself for making those major financial decisions.