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Understanding Credit Scores

The credit industry has been dealing with credit scores for many years, but there has always been a certain mystique about how they were calculated. However, the calculation can easily be defined so that loan originators and processors can have the information to help counsel their borrowers through the home buying process. Based on the information below, in a pre-qualification scenario it is best for the borrower to make any corrections or reduction in loan balances at least six months prior to beginning the home buying process. This information probably will be enlightening to some lenders, and others will see it as a good reminder.

The calculation for credit scores is weighted as follows: payment history – 35%, outstanding balances – 30%, credit history (length the account has been opened) – 15%, type of credit –10%, and inquiries – 10%.

Payment History Details
It is logical that the actual payment history has the most impact. The model for credit scoring evaluates the severity of late payments, frequency of late payments, and the most recent late payments. Late payments on revolving credit effect the credit score more than installment late payments

Late payments within zero to six months most affect the credit score, with late payments within 7-23 months having a moderate effect on credit score. Late payments over 24 months old represent a minor impact on the credit score.

Details of Outstanding Balances
Revolving accounts with an outstanding balance of now more that 49 percent of the credit limit result in the best scoring. Borrowers who have multiple cards but mainly use one card that is always close to the high credit limit are actually hurting their credit score. For example, the credit score will be higher if the borrower has four cards that each has les than 49 percent of the available credit as the outstanding balance, rather than maintaining one account with a balance that is constantly close to the high credit limit.

The best scoring requires a minimum of three to five revolving accounts. Active revolving accounts that have been used in the last six months provide the best scoring.

Credit History Details
This category relates to the length accounts have been open, which is a major factor, especially in evaluating marginal cases. The longer the account has been opened, the better when it comes to credit scoring, particularly revolving accounts.

Credit acquired within 30 days is a big hit against the credit score. If the borrower has a credit card account that has been open a long time, it is advisable for that account to be retained when considering any accounts that might need to be paid and closed in order to qualify for the loan.

Type of Credit
Installment loans made to finance companies are a big hit against the credit score, and any late payments on these types of loans represent an additional adverse effect on the score. While many of these accounts are used by borrowers who take advantage of “90 Days Same As Cash” type promotions, many finance companies charge higher interest rates and can indicate that the borrower’s credit could not qualify for more favorable rates available through a bank or credit union.

Details of Inquiries
Inquiries from the same type of creditor within a 14-day period only count as one inquiry in calculating the score. The credit scoring model “stops” counting inquiries in the calculations when inquiries reach seven to ten in a 12-month period.

Credit scoring is very favorable to balanced credit use. Extremes represent the biggest hits: lack of credit versus excessive credit.

A Few More Facts
A common occurrence in dealing with the payment of collection accounts is that in some cases, paying the collections will cause the credit scores to decline. Paying the collections changes the “last activity date” to a current date. So even if the accounts were opened over 24 months prior to the last report date, paying the collection will make the last activity be a current “read” in calculating the credit score.

Corrections, debts being paid, or judgments being released will not effect scoring for 30 days. It will be somewhere within 30 days of the corrections or pay off of debts, for the credit score to be affected.

In the model for credit scoring the range of scores can be 350-850. Freddie Mac and Fannie Mae continue to use credit scores in delivering new products to the industry and developing the level of risk they are willing to take for certain hybrid products. Risk-based pricing continues to dominate secondary marketing and along with thier automated underwriting systems, will continue to be a vital component in the mortgage industry.

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