Credit scores have been around for so long, it’s hard to remember that they didn’t always play such a significant role in our financial lives. And if you’re like a lot of folks, the origins and utility of credit scores are still a mystery. So, let’s dig in and shed some light on the why and how of these methods for measuring creditworthiness.
A credit score is a three-digit number, generally ranging from 300 to 850, that represents an individual’s creditworthiness. Companies use credit scores to determine your credit risk and then use that information to decide whether to offer you a credit card, an auto loan, or a home mortgage. Your credit score doesn’t just determine yes or no on a loan; it can also determine the types of loans you can qualify for and how much interest you’ll have to pay.
The first credit scoring system was introduced by the company Fair, Isaac and Company (now known as FICO) in 1958. However, the universal credit score we use today wasn't invented until 1989. VantageScore, an alternative to the FICO score used by the major three credit bureaus (Equifax, Experian, and TransUnion), wasn’t introduced until 2006.
How are credit scores calculated?
Your credit score is based on a variety of factors. Each category carries a different level of influence when determining your score, with payment history being the most crucial factor and credit mix being the least influential.
-
Payment History (35%)
-
Credit Utilization (30%)
-
Length of Credit History (15%)
-
New Credit (10%)
-
Credit Mix (10%)
Payment History
Payment history is your history of making payments consistently and on time. It also factors in missed or late payments, previous bankruptcy filings and debt collection. Because payment history is such an important factor in determining you credit score, any delinquencies can significantly lower your score.
Credit Utilization
Credit utilization is the percentage of your available credit that you're using – the current amount you owe divided by the total of your available credit limits. Credit lenders like to see credit utilization ratios at or below 30%. Consistently having less than 30% utilization can help raise your credit score, while owing more than 30% can negatively impact your score.
Length of Credit History
Length of credit history takes into consideration the ages of your individual credit accounts as well as the average age of all your accounts. Opening new credit accounts will bring down the average age of your accounts. The longer your credit accounts have been open, especially with a solid payment history, the better.
Which is why some people get credit cards or open accounts for their pre-adult children, even if they are managing the payments. It can be a helpful way to set your children up for the future.
New Credit
New credit looks at the number of new accounts you have applied for recently – regardless of whether or not you were approved. Numerous “hard inquiries” within a short period of time can suggest to lenders that you’re taking on more debt than you can pay back. This is why each hard inquiry can ding your score a few points. (More about “soft inquires” in a minute.)
Credit Mix
Credit mix is the variety of types of credit you have. Lenders look for a mix of credit cards and revolving credit (auto loans, student loans, and mortgages). Although paying off debt is important, you may see a temporary dip in your score once you completely pay off a loan, because it lessens your total credit mix.
Bizarre, but true.
Credit Score Ranges
Credit score ranges vary slightly based on the scoring model used to calculate them but generally follow this model:
300-579: Poor
580-669: Fair
670-739: Good
740-799: Very good
800-850: Excellent
In most scoring models, borrowers need a minimum score of around 670 for their credit to be considered “good.” Most consumers have credit scores that fall between 600 and 750. Generally speaking, the higher your credit score, the more likely you are to appeal to lenders.
Common Misconceptions
Checking your own credit score will lower it
Credit card companies and credit monitoring apps may show you a free credit score. Checking your own credit score like this does not lower your credit score. This is considered a “soft inquiry,” just like anytime one of your current creditors checks your credit or a company checks to see if you qualify for preapproval offers. Only hard inquiries impact your credit score.
Carrying a small balance helps your credit score
Many people think letting a small balance rollover from month to month is a good thing, but this will not improve your credit score. While you don’t want a card to close from disuse, carrying a balance is unnecessary. It is best to completely pay your balances in full whenever possible. This helps you maintain a low credit utilization ratio and avoid interest charges.
Income affects your credit score
Your credit score is not impacted by how much you make, your occupation, or your employment status. While lenders may consider your income when applying for higher loan amounts, it does not go into determining your credit score.
Paying off debts erases them
Late or missed payments remain on your credit report for up to seven years from the date you missed the payment, even after the debt is paid off. The same is true of debts that went to collections. Some bankruptcies can even stay there for up to 10 years.
How Credit Scores Affect Mortgages
Your credit score is an important factor in determining the approval and terms of a mortgage loan. First and foremost, your credit score helps the lender determine whether you meet the requirements to qualify for a mortgage.
There's no “magic number” that guarantees you'll be approved for a mortgage. Most lenders require at least a 620 score for a conventional loan. Those with a lower score may still qualify for other loan types, such as an FHA loan. FHA loans typically require a minimum 580 credit score.
Your credit score also determines what interest rates you’ll be approved for. Those with higher credit scores will often be offered better interest rates. A good credit score can also grant you more favorable loan terms, such as a lower down payment, reduced PMI (private mortgage insurance), or a higher loan amount.
It is also important to note that the score you see when you check your own credit online won’t necessarily be the same score your mortgage lender sees when they pull your credit. Creditors and lenders use a different credit scoring model. Because they use a tougher model, the credit score they pull will often be lower than the number you find on free site.
Tips for Improving Your Credit Score
The difference between taking out a mortgage with a 620 credit score versus a 670 score could be up to hundreds of dollars in interest a month. Over the lifetime of the loan, having a better score would save you tens of thousands in interest payments alone. As you can see, you’re better off improving your score as much as you can before applying for a mortgage.
Aside from being proactive with making on-time payments and paying down your debts, here are a few tips for improving your credit score before applying for a mortgage:
Dispute info
Regularly pull your credit reports and report any errors. You can file disputes with each of the three credit bureaus (Equifax, Experian, and TransUnion). You’d be surprised how common credit errors are. Correcting them is a quick and easy way to repair your credit.Debt-to-Income (DTI) Ratio
We already talked about the 30% credit utilization rule, but the debt-to-income ratio is another important number to be aware of. Your DTI ratio weighs your monthly debt payments (minimum credit card payments, auto loans, student loans, and any existing mortgages) against your gross monthly income. Lenders generally prefer a DTI of 43% or lower. Paying down your debt improves both your DTI and your credit score.
Authorized User
One tip that is especially helpful for those with a limited credit history is to become an authorized user on another person’s credit card. Even without actually using the card, you will still benefit from that person’s good payment history going on your credit report. Just be aware that their late/missed payments would also go on your report!
Don’t Open or Close Accounts
In the months prior to applying for a mortgage loan, you will want to refrain from both opening new accounts and closing old ones. Opening new accounts can increase your debt-to-income ratio and also counts as a hard inquiry on your credit report.
On the flipside, even if you have a credit card paid down to zero, you don’t want to close that account prior to applying for a mortgage loan. Closing an account that is several years old will bring down your average credit age. Your credit utilization will also be impacted since you will no longer have that line of credit counting toward the available credit limit. Both of these will bring down your credit score.
Credit Scores Matter
Credit scores have a significant influence our ability to secure loans and determine the terms we are offered. Understanding how credit scores are calculated and the factors that influence them is crucial for maintaining a good credit standing. Taking proactive steps to improve credit can make a significant difference in securing more favorable loan terms. Ultimately, a higher credit score translates into better financial opportunities and savings over the long term, especially when it comes to home mortgages.
