Part I: 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 of 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 lower score between 500 and 600. Here is a sample chart that illustrates how an underwriter interprets the score in terms of risk, and how the interest rate is affected.
Part II: The Five Factors of Credit Scoring
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.
Secondly, it is often beneficial to compile a Tri-Merge Credit Report. This combines the scores provided by Fair-Isaac (FICO) with the score generated by TransUnion (Empirica) and the Beacon Score produced by Equifax. The lender should be provided with this rounded profile because these three scoring systems can vary in their results. The lender is going to look at the middle score and throw out the other two. In many cases, this works to the borrower’s advantage.
Part III: Dealing with Challenges
Typically, a person with a bad credit score is in this position because they lack structure in their life. There are, of course, cases where unplanned health or employment complications are to blame, but for the most part, these are individuals who lack the discipline to pay their bills on time or curb their spending. This is your opportunity to be the “knight in shining armor” that provides them with a simple roadmap to get back on track. Let’s take a look at some examples that can help to quickly improve less-than-perfect credit scores for the potential homebuyer:
Let’s say we have a borrower who needs to do a stated income loan to buy the home they want, but they have a credit score of 664. They have a concentration of credit card debt on one card; let’s say $17,000 on a card with a $20,000 limit. At the same time, they have four or five additional credit cards, all with a zero balance. I would advise the borrower to distribute the debt over the cards that are available to work with. This changes the ratio of debt to available credit, and can cause their credit score to pierce through that magical threshold on our chart (from Part I of this series), and put them in the 680-699 category of having good credit.
Another thing to take into consideration in a case like this is what percentage each of the five factors measure in the resulting credit score. Let’s say we have a borrower with a credit high (the maximum debt allowance on all cards, combined) of $20,000. They have one card that is used for business purposes that is pushing the limit. I would advise the client to get two new cards, each with a $5,000 limit, and once again, spread the debt out over the cards leaving a 30% margin of available credit on all the cards. This will affect the factor of credit history, but this specific factor only affects the overall score by 15%. The big difference, once again, is the resulting impact on the credit balance factor, which has a 30% influence on the overall score and can cause the overall calculation to pierce through the next level on our chart.
Conversely, the borrower should be advised not to close any existing credit card accounts, even if they are at a zero balance. Some people think they are doing themselves a favor by having fewer cards, and they lose out on the credit history factor. Even if the borrower does not have a good rate on an old credit card, they are rewarded for having the long-term credit history, and from time to time they should make a small purchase to keep the account in an active status.
These are just a few examples of what borrowers can do to improve their credit score when they consider buying a home. If they are disappointed by the fact that they cannot get the A-Paper loan up front, I would continue to monitor rates and their specific loan scenario on an ongoing basis and advise them when they will have a chance to turn this situation around. The new mortgage debt will temporarily drop the score, but once the first payment registers as “paid,” the score will begin to go up again and eventually present the opportunity to refinance at a lower rate.
Part IV: Credit Remediation
If you have clients in need of credit remediation, and especially if you live in an area where this is an overall problem within the population, you should seek to align yourself with a credible referral source for credit repair. While government web sites will suggest that self-help may be the best option, keep in mind that for the most part these people lack discipline when it comes to spending and making payments. They are not likely to have the diligence to research and remedy their own credit problems.
The Federal Trade Commission regulates credit repair services, and they provide free information to help consumers spot, stop, and avoid businesses with fraudulent, deceptive, or unfair practices.
Be familiar with the Credit Repair Organizations Act (http://www.ftc.gov/os/statutes/croa/croa.htm) as you seek out a genuine ally in this area. Research their background and make sure this company will cast a good reflection on you when you refer your clients to them.
I have a company that I use for this purpose, and they have a proven track record of keeping in touch with my clients and me on a regular basis, while my clients are going through the remediation process. Their work is 100% guaranteed, which means that if they are not able to meet the commitments outlined at the commencement of the process, then there is no charge to the consumer.
I have also developed marketing literature on the topic of credit repair, which I pass out to my clients to help them understand credit scoring. This provides them with information about what they can do to immediately help improve their credit score. Subsequently, in many cases, they are able to obtain the financing for the home they wish to purchase.
From there, I continually keep an eye out for new options as their credit standing improves, and seek to place them in a lower interest loan as time progresses. I feel it is my responsibility to do more than simply quote rates and provide a loan, but rather to help them manage their debt on an ongoing basis to meet their long-term goals.
Let me know when you would like to set an appointment and talk about what I can do to assist your clients who are in need of credit remediation services. I look forward to the possibility of assisting you in this area.
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