No matter if you’re dreaming of a white picket fence or a condo on the seventh floor, there’s a good chance you’re going to need a mortgage like 64 percent of homeowners in America. Getting a mortgage means somebody is going to peek at your credit score while they’re trying to determine how big of a credit risk you are — or if you’re credit-worthy at all. Before you go in for your pre-qualification, it’s a good idea to get up to speed on exactly what a credit score is and what metrics are used to create it.
What is a Credit Score?
Theoretically, your credit score is a measure of how serious of a credit risk you are. After all, a lending institution doesn’t want to take a chance on somebody who they know won’t pay back their loans. For those borrowers who fall in that space between a guaranteed payment and a guaranteed default, credit scores double as a way of establishing rates — a higher risk means a higher rate.
Is it fair to judge you based on your credit score? There are many reasons why your credit may be less than stellar. The credit rating system that we’re all subject to in the US isn’t perfect. If you’ve had a serious injury and your medical bills went into collections, lost a job and missed a lot of payments or a former spouse decided to go nuclear on your credit cards, you will be judged unfairly.
I’m sorry to say that there’s nothing you can really do about a credit report that doesn’t show you in the best light except try to clean up the damage as well as you can and be patient in the meantime. The good news is that if you learn as much as you can about credit now, you’ll be able to make the right decisions regarding those outstanding items moving forward.
Calculating Credit Scores
The credit score most commonly used to help determine how risky you are is provided to your bank through the Fair Isaac Corporation, this is the FICO score. Once your bank has this figure, they push it and other information they’ve gathered about you through their system to determine your creditworthiness. Even though your FICO score isn’t all they base their judgement on, it’s a big part, so the bigger that score, the better off you are.
FICO scores range from 300 to 850. The higher on that scale you are, the more creditworthy you’re generally assumed to be, and vice-versa. Most lenders like to see a score above 700 for mortgages, though FHA-backed loans will now approve some buyers with scores as low as 600. How you handle your credit can make a big impact on that number, but different activities have different amounts of influence.
Credit scores are figured based on a proprietary algorithm, so we’ll never know the exact ins and outs, but currently, Fair Isaac tells us that this is how they weight things:
Payment History — 35 percent. This one is pretty self-explanatory. FICO likes it when you make your payments on time and doesn’t really care for it when you pay them late. A late payment doesn’t necessarily mean one that’s paid after the due date, though. A payment isn’t considered late by FICO until your institution reports it late — FICO has no way of knowing otherwise.
Amounts Owed — 30 percent. FICO wants to know that you’re not overextended. They determine this by comparing how much of your credit you’re currently utilizing to the total amount of credit that has been extended to you. If most of your accounts are revolving at high percentages of their credit lines, this is going to hurt your credit score significantly. Try to keep your revolving debt to less than half of the credit lines, you can thank me later.
Length of Credit History — 15 percent. The longer your credit history, the better, provided that the things in your credit history are mostly positive. The length of your credit history is determined by the age of your oldest account, but this metric also looks at the average age of all your accounts and how long it’s been since you used them.
Types of Credit Utilized — 10 percent. Ideally, you should have a mix of credit types, including mortgages, other secured credit like an auto loan, credit cards and retailer accounts. The bigger the mix, the better the score, provided you’re not overextending yourself.
New Credit — 10 percent. New credit is inevitable from time to time, but the more new accounts you have, the bigger of a risk you represent. Not only do they lower your average account age, they also tend to come with credit inquiries that will stay on your report for a while.
There are other things that definitely affect your credit score, including collection accounts, number of credit inquiries and public record items like bankruptcy or foreclosure. Under the new FICO 9 algorithm, your bank may soon be ignoring medical collections, so ask your lender if this is a concern.
Getting a Copy of Your Credit Report
Your credit report belongs to you — and you have a right to a copy of it. This is more than just a platitude, it’s a truism that was enacted into law in 2001 and became a requirement for all reporting agencies as of December 2003. Since then, you’ve been entitled to a free copy of your credit report each year, regardless of the reason.
This is a great way to check your report for accuracy, discover long-forgotten bills you intended to pay off and generally tune your FICO score up in preparation for a mortgage loan. Although you won’t see a score with your free report, you can spend a little extra money and get an estimated FICO if you’re worried. These free credit reports are available through the website AnnualCreditReport.com.
You can request changes, updates and dispute problems through the various credit reporting websites by following a simple online wizard designed to make the process as painless as possible. By keeping tabs on your credit report, you can avoid any surprises when it comes time to finally apply for your mortgage.
Improving Your Credit Score
If your credit score is down in the dumps, or you’d simply like to see how good it can get, there are a number of things you can do starting today. We already discussed disputing inaccurate information, but that’s not the only thing that will help your credit. Try these tips to improve your score even more:
Start making on time payments. There’s little that can help your credit score in the short term as fast as making on time payments. Set a reminder on your smartphone or schedule an automatic payment to help keep yourself on track each month and remember to prioritize your spending. This is where a budget comes in really handy.
Catch up accounts that are behind. Just because an account has a bad payment history now doesn’t mean that it’s a goner. Call the company and see if you can come to an arrangement on the late amount, they may be willing to redistribute the payments or start your payment plan over again. From that point forward, pay your payments on time, every time.
Pay down your debt. IRS refunds and those stray “extra” checks we get a few times a year are a great way to fund household projects, pay for trips and cover birthdays and holidays, but they can also help you improve your credit score. Use those bonus checks to pay off or pay down your debt instead and you’ll see your credit score climb.
Get a credit card. Get a single credit card if you don’t already have one and use it for the things you’d buy anyway. Pay that amount off in full before it ever reaches the billing stage and your credit report will quickly benefit. Credit card companies love cardholders that pay in full, but don’t let them convince you to open a bunch of new accounts — that can backfire on you.
Be patient. Even if you’re doing everything right, it’ll take time to improve your credit score. The changes you implement today can take six months or a year to really benefit you. That’s not to say that they’re not worthwhile — they’re changes that will affect your life forever if you turn them into habits. Plan ahead and start focusing on your credit at the same time you’re saving for your down payment.
The Bottom Line: Understanding Your Credit Score is Vital to Financial Success
Sure, your credit score is just a bunch of numbers that you may never care about again after your mortgage is secured, but right now that’s your goal, isn’t it? You need to learn to work the system or you’ll be plagued with high interest rates and may face a serious lack of offers when it comes to emergency loans or credit cards to cover unexpected expenses. Learn about your credit score, understand how it works and you’ll be armed for life.
Unfortunately, credit scores are increasingly used for other parts of our lives besides borrowing money. There’s a good chance that your apartment manager or employer pulled a credit report before allowing you to darken their doorstep. Some companies still pull credit reports for debit cards and bank accounts, too — so listen up. Having no credit, or worse, really bad credit, can make this modern world very difficult to navigate.