Having good credit is more important than ever to those seeking mortgage financing. A few points either way in one's credit rating can result in significant differences in the interest rate one would receive, or even the ability to qualify for the mortgage at all. To illustrate the value of good credit (or the cost of poor) let's apply standard Fannie Mae adjustments to a purchase scenario with a twenty percent down payment and varying credit scores. Beginning with the current baseline measure for excellent credit -a mid-score of 740 - and a hypothetical rate of 3.875% here is what happens as scores drop. Below 720, the rate would increase to 4.0%. Dipping to just under 700 the rate would increase to 4.125%, and below 680 the rate would jump to 4.625%. Beyond the cost to interest rate, all loan programs have minimum credit score requirements. Even a one-point difference can disqualify the loan option one needs to support their desired purchase range.
The factors that determine good credit scores are often ambiguous and counter-intuitive. Certain steps that may initially prove detrimental can serve to improve overall scoring after several months' time. And many consumers are dismayed to learn that efforts they've made to improve their credit rating actually ended up hurting their scores. Adding to the confusion is the fact that the algorithms employed by the credit bureaus -Experian, Equifax, and TransUnion -are proprietary secrets. Through experience, however, we know of sound steps one can take to develop and maintain good credit. To help you with this endeavor, here are some general points to be aware of, along with things you can do to improve your credit, and potential pitfalls you should avoid.
What determines your credit scores?
Since the credit bureaus' modeling systems are carefully protected trade secrets, there is no perfect answer as to what makes up one's scores. But, loosely defined, there are three main pillars upon which credit scores are built:
- Credit balance to credit limit ratio. If you are carrying a balance on your credit card from month-to-month, the balance should not exceed 33% of the card limit. Many consumers wrongly assume that their credit will not be adversely affected as long as they make their minimum payments on time. Unfortunately, if your balance exceeds 1/3 of the card limit your scores are being compromised. And the more leveraged you are, the more adverse the affect on your credit rating.
- Payment history. Late payments obviously hurt your credit rating. The more recent the late payment, the worse it damages your scores. With time, the adverse affect on your scores will temper.
- Miscellaneous items. This includes factors such as multiple inquires, negative judgments found in public records, etc. Multiple inquires within a 30-day period that show on your credit report can lower your scores by as much as 20 points.
Steps you can take to improve your credit scores.
- Develop depth of credit. Mortgage lenders typically require that prospective borrowers demonstrate the ability to manage credit. A borrower's credit report should show a minimum of 3 credit trade lines that have been actively used over a period of 24 months.
- Variety of credit. A history of maintaining different types of credit will build a good credit rating. Having both revolving lines of credit (credit cards) and installment loans (car, student, etc.) will build a stronger credit rating.
- Credit lines must be actively used. Having lots of credit cards that you don't use is of no benefit to your credit rating. Try to regularly use all of your cards. One way to do this is to designate specific uses for certain cards, such as using one to purchase gasoline.
- Avoid having too many credit cards. Although it is beneficial to demonstrate good depth of credit and a borrower should ideally show at least 3 trade lines, it is difficult to manage too many cards and this may increase the odds of late payments.
- Spread balances between cards to avoid being too leveraged on one. Some borrowers will transfer their various card balances to just one card to take advantage of a lower interest rate. But if the new balance exceeds 33% of the card's credit limit, they are compromising their credit rating. It would be better to spread the overall credit balance between several cards.
Potential pitfalls to avoid.
- Do not make late payments. This is obvious, but essential.
- Do not open and close too many cards. Closing a credit card will actually hurt your scores for a few months.
- If paying down credit balances to improve scores, use the card for a minor purchase right away. Paying balances down to zero and not using the card is suggestive of a pending closure and can hurt your scores.
- Do not allow multiple creditors to pull your credit report as this will hurt your credit rating. For example, if shopping for a car, do not provide your social security number until you are sure you will be buying from a particular vendor.
- Be extremely careful if satisfying any derogatory postings such as collections, legal judgments, or tax liens showing on your report. If not done properly, you might actually compromise your scores by taking a negative item from the past and updating its effective record with the credit bureaus to the present.
Finally, major credit issues such as foreclosures, bankruptcies, loan modifications, etc. can sometimes be removed from credit report. While there is no guarantee of success, the process takes time and you will likely need professional guidance. You should exercise caution in choosing whom to work with as there are many who will charge a lot but do little to help you. Beware of "dispute letter services," as many will collect huge fees to send out a couple letters, which you could easily handle on your own.