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What's the Score? How Credit Scores Work

Posted by:  Chip Poli
2013-01-09 06:47:43

While credit has always been a component of responsible mortgage lending, the notion of credit has changed over the years. Now, instead of a lender looking at a credit report to see if there are any late payments, credit scores are the determining factor for most programs. What is a credit score?

There are several different types of credit scores used by businesses today but the score used in mortgage lending is called the FICO score, or simply “FICO.” FICO is the acronym for the Fair Isaac Corporation that developed the algorithm which calculates credit scores for mortgage companies.

How Credit Scores Work

The credit score is a three digit number ranging from 300 to 850 and is an indicator to the likelihood of default on a loan. The higher the number the better the credit.

Lenders use the FICO score to not only evaluate a loan approval but FICO scores can also be used to determine a mortgage rate for a client. For example, if two borrowers each have five percent down for a mortgage and one has a score of 750 and the other 650, the interest rate can vary by as much as one-half percent on a 30 year fixed rate mortgage. The credit score evaluates recent credit activity and assigns a number arrived at by reviewing five key factors.[list style="guard"]

  • Payment History
  • Available Credit
  • Length of Credit
  • Types of Credit
  • Inquiries[/list]

The Payment History has the most impact on a credit score, accounting for 35 percent of the score’s total. The payment history reviews payment patterns and logs when payments were made. If any payment is made more than 30 days past the due date on the account, the credit score will drop. If a payment is made more than 60 days the score will drop even further. 90 days? Further still.

In addition to a late payment on an account, if there are multiple accounts with late payments credit scores will suffer. If an account is placed into collection or worse, charged off by the creditor completely, the scores will fall dramatically.

By making sure payments are received on or before the due date on all accounts each and every time, credit scores will rise. For those with damaged credit, the best way to reestablish credit is to make timely payments.

The Available Credit category counts for 30 percent of the credit score. Available credit is described as the amount of credit available to the borrower compared to the credit limit. When a lender issues a credit card there will be a credit limit and as the borrower begins to use the card the balance will increase.

If the balance begins to approach the credit limit the scores will begin to fall and if the balance temporarily exceeds the credit limit scores will fall even more. The ideal balance for the purposes of increasing credit scores is approximately 30 percent of the available credit. If the credit limit is $10,000, by keeping a balance around $3,000 FICO scores will be on the rise.

Credit Score Calculation

The Length of Credit is simply how long the borrower has used credit and represents 15 percent of the score. Consumers can do little to affect this category other than to wait and continue to use credit responsibly.

Finally, the Type of Credit used and Credit Inquiries both account for 10 percent of the FICO score. Certain types of credit utilization helps a credit score more than others. For example, making timely mortgage payments helps a score as well as utilization of a credit card.

An Inquiry is an event when a business checks a consumer’s credit history as a result of applying for a credit account. Multiple inquiries for several different credit accounts in a relatively short time frame will harm a credit score.

FICO scores really aren’t a mystery once explained and the scores do in fact make sense.

By concentrating on the first two categories of Payment History and Available Credit, you will soon find that everything else will fall into place. Make timely payments and use credit when needed and use it responsibly. When you do, you’ll get the best mortgage rates available.

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