By Robert S. Kutner, Esq.
The recent economic downturn and increase in foreclosures has made lenders much more sensitive to the risks they undertake when lending. Lenders have tightened their standards when evaluating the creditworthiness of borrowers.
Some prospective home-buyers who have applied for financing with the belief that they would be approved at the lowest advertised interest rate have been surprised when told they qualify only at a higher rate. The explanation may not be based on the borrower’s income or the loan-to-value ratio for a property, but instead may lie with the murky topic of a consumer’s credit score. Educating consumers about the factors that are used to calculate their credit scores will enable them to refrain from certain activities that may adversely affect their scores.
Calculating a Score
Credit scoring is a method for providing a snapshot of a borrower’s credit risk at a particular point in time by applying a mathematical formula to a borrower’s credit history, producing a three-digit numerical score that is intended to identify the risk that the borrower will fail to repay a loan. The most widely used credit scores are those developed by Fair Isaac Corporation and are commonly known as “FICO®” scores. Fair Isaac was founded in 1956. Its purpose is to assist lenders in managing credit accounts, detecting credit fraud, and automating business decisions. The benefit of FICO® scores is that they can be delivered almost immediately, helping lenders to process loans and speed approvals. It is estimated that FICO® scores are obtained by lenders for more than 75% of mortgage loans.
FICO® scores range from 300 to 850. According to FICO®, there are five factors that are used to determine a consumer’s score: (1) payment history accounts for 35% of one’s score; (2) the amounts owed comprise 30%; (3) the length of credit history is 15%; (4) newly opened accounts and inquiries amount to 10%; and (5) the mix of credit cards, retail accounts, installment loans, and mortgage loans determines the final 10%.
FICO® scores exclude the borrower’s age, race, color, religion, national origin, and marital status. They also exclude where the borrower lives, as well as the borrower’s salary, occupation, employment history, rental agreements, child support obligations, and interest rates on particular accounts. Most consumers fall within the 600 to 700 range. A score of 720 or above is often considered excellent credit; 680-719 is good; for scores 620-679 lenders generally take a closer look at the consumer’s file; 585-619 puts one at higher risk and generally makes one ineligible for the best rates; and a score of 584 or below makes lenders question whether to make credit available. The exact numerical range for each category is determined by the lender.
Analyzing a Score
Lenders may purchase FICO® scores from each of the three major reporting agencies: Equifax, Experian (formerly TRW), and TransUnion. The numerical scores from each agency are not identical. It is not unusual for them to vary by as many as 50 points. The primary reason for the variation is that the financial information received by each agency differs. While the credit reporting bureau controls the data, FICO® controls the scoring formula. In one ituation, a consumer reported falling just short of the score needed to qualify for the best rate. He went to another lender that used a slightly different formula and was able to obtain a loan that generated savings of more than $20,000 over the life of the loan.
With regard to payment history, FICO® reports that it takes into consideration the frequency of late payments as well as their length and how recently they occured. For example, a 30-day late payment last month will carry greater weight than a 90-day late payment five years ago. When factoring in the amounts owed, the FICO® formula considers the amount owed, even if paid in full every month. It also includes how many accounts have balances, what type of loans (for example, installment or revolving credit) have balances, and the percentage of that original loan that has been repaid. Paying down installment loans is a good sign, and generally, the longer the credit history, the better the score. Taking on new credit can adversely affect one’s score, however the FICO® formula distinguishes between opening new accounts and merely interest rate shopping. Rate shopping is generally not associated with a higher risk of default. Finally, the score for one’s account mix is affected by the kinds of credit accounts one has and the number of each. It varies for consumers with different credit profiles.
Improving a Score
To obtain a better score, borrowers should pay bills on time. Simply closing an account in which a payment was missed will not eliminate it from a credit report. It is also recommended that the borrower pay off debt, rather than moving it around. Unused credit cards should not be closed, since having fewer cards may lower one’s score. Finally, avoid opening several new accounts within a short period of time, since this will lower one’s score.
Under current federal laws—the Fair Credit Reporting Act and the Equal Credit Opportunity Act—when a consumer’s application for credit is rejected, the consumer must be provided with the reason for the rejection
within 30 days. Historically, however, consumers have been kept in the dark about their credit scores. It is recommended that before a prospective buyer begins the process of searching for a home, they check their credit
report at each of the three reporting agencies. Federal law provides that a consumer is entitled to receive one free credit report per year from each agency. A free credit report and score s available at www. experian.com, and a 30-day free trial of a credit monitoring product that includes one’s credit score is offered at www.fico.com and at www.transunion.com. By submitting a request to one of the agencies every four months, erroneous financial and background information can be corrected before it becomes an obstacle to financing.
Through education about the factors used to formulate credit scores, consumers can position themselves to obtain the best financing rates. They can also avoid activities that may reduce their scores.