Credit Scoring Explained

Credit Scoring
Good Credit Translates into Lower Rates for the Consumer. In the 1960s, Fair Isaac Corporation started working on a system lenders could use to evaluate the likelihood of receiving repayment on loans. Prior to that, it was really a matter of trusting an individual to be a "man of his word," so to speak. Fair Isaac sought to take human error out of the equation with a reliable system that could determine whether or not consumers were truly worthy of credit, and thus FICO was born. This evolved to become the standard for lenders by the 1980s.
 
Credit scoring has an enormous impact on a borrower's ability to purchase a home. It can mean the difference between getting a good interest rate and the home of their dreams, or whether they even qualify at all. For this reason, it is important for borrowers to understand the credit scoring process, and to know what their credit score is when they look to obtain mortgage financing. What the credit scoring model seeks to quantify is how likely the consumer is to pay off their debt without being more than 90 days late on a payment at any time in the future. Credit scores can range between a low score of 350 and a high of 850. The higher the client's score is, the less likely they are to default on their loan. Only a rare one out of approximately 1300 people in the United States have a credit score above 800. These are the slam-dunk clients that walk away with the best interest rates. On the other hand, one out of eight prospective home buyers are faced with the possibility that they may not qualify for the loan they want because they have a score between 500 and 600. 
 
There are five factors that comprise the credit score. They are listed below in order of importance, just as an underwriter would look at the score: Payment History: 35% impact. Paying debt on time and in full has a positive impact. Late payments, judgments and charge-offs have a negative impact. Missing a high payment has a more severe impact than missing a low payment. Delinquencies that have occurred in the last two years carry more weight than older items.
·
Outstanding Credit Balances: 30% impact. This factor marks the ratio between the outstanding balance and available credit. Ideally, the consumer should make an effort to keep balances as close to zero as possible, and definitely below 30% of the available credit limit when trying to purchase a home.
·
Credit History: 15% impact. This marks the length of time since a particular credit line was established. A seasoned borrower is stronger in this area.
·
Type of Credit: 10% impact. A mix of auto loans, credit cards, and mortgages is more positive than a concentration of debt from credit cards only.
·
Inquiries: 10% impact. This quantifies the number of inquiries that have been made on a consumer's credit history within a six-month period. Each hard inquiry can cost from 2 to 50 points on a credit score, but the maximum number of inquiries that will reduce the score is 10. In other words, 11 or more inquiries in a six-month period will have no further impact on the borrower's credit score.
·
Remember, a computer that's not taking any personal factors into consideration calculates these scores. When a credit report is generated, it is simply today's snapshot of the borrower's credit profile. This can fluctuate dramatically within the course of a week, depending on the individual's own activities. The borrower should be made aware of this when they enter into the loan process, and know that it's not in their best interest to go out on a shopping spree. They need to make sure they are not creating a negative impact on the score while the lender is reviewing their file.

Return to Local Resources