Home Loan Basics: Credit Considerations
To you, your credit history may simply be the three numbers you pull up through an app on your phone. But what’s behind your score? How is it calculated? What can increase it and what can sink it? Not knowing what affects your score can be an obstacle. After all, it is a major player, if not the most important factor, when you want to get a credit card, apply for a car loan, or purchase a home. Your credit score is based on your present financial situation and also your past decisions. It’s a work in progress, fluid when it comes to current actions and often shaped by events going as far back as 10 years.
Let’s pull the curtain back on credit score calculations and explore what appears on your credit report and how it can affect your loan application. From there we can discuss actions that could improve your credit score and others that could hurt it.
Credit Reporting Bureaus
Equifax, Experian, and TransUnion are the three major credit bureaus in the U.S. They gather and maintain credit information on individuals and businesses and then sell this information to other companies. Credit bureaus receive information from banks, credit card companies, finance companies, and other companies that offer credit to individuals and businesses. Collection agencies are another source used by credit bureaus. In addition to the information provided to them, bureaus also search public records for property or court documentation.
Each bureau receives, records, and stores your credit information in its own way. The information Experian has about you will be similar to that of TransUnion and Equifax, but not identical. One bureau may have information that the others did not find through research. A creditor may have only reported information to one bureau. Or one bureau may have more up-to-date information than the others. Because of these variations, a unique credit score is generated for each bureau, based on its own information.
Analytics software is used to convert your credit information into a credit score. There are a number of companies that provide this software, but FICO software is the most widely used. Basic FICO scores range from 300 to 850. FICO breaks down this range into the following segments:
- 800 to 850 – Exceptional score
- 740 to 799 – Very good score
- 670 to 739 – Good score
- 580 to 669 – Fair score
- 300 to 579 – Poor score
FICO also offers a general breakdown of the factors they use to determine credit scores. These percentages are based on the general population and can vary by individual.
- 35% Payment History
- 30% Amount Owed
- 15% Length of Credit History
- 10% New Credit
- 10% Credit Mix
How Your Credit Score Affects Your Loan Application
In general, the higher the credit score, the lower the interest rate. Lenders view your credit score as a reflection of your credit worthiness, and you can expect to be offered the best interest rates when you score 740 or better. In contrast, when you have a poor credit score, the interest rate you are offered may be one of the highest, if you are offered one at all.
A high credit score may give you access to a variety of product options. On the other hand, a low score can limit you to just a few products. However, a low score doesn’t mean that you won’t have any mortgage options. For example, borrowers with a credit score of 500 meet the minimum eligibility requirement for an FHA loan.
Your Tri-Merge Credit Report
After you apply for a home loan and give your permission, the lender will pull a tri-merge credit report. This report merges all your credit information from Experian, Equifax, and TransUnion, but still provides an individual credit score from each bureau. In addition to credit scores, the report is broken into a number of sections.
Personal and Employment Information
Your personal information is used to verify your identity. You’ll find your name and any variations of it that you have used. This could include some misspellings of your name. Your current address is listed as well as your birth date. Some of your employers will be listed, but it is not a complete history. It’s limited to the employers you identified on past credit applications.
In most cases, your account history will make up the largest section of the report. Both open and closed accounts are listed here. Each listing includes the name of the creditor, account balance, limit or original loan amount, status of the account, and payment history, including late payments. Information about collection accounts will be noted. Lenders spend a significant amount of time reviewing your accounts and making note of any negative information.
Bankruptcy is currently the only event that is provided in the public records section. The type of bankruptcy and its status is documented. A Chapter 13 bankruptcy remains on your credit report for seven years and a Chapter 7 for ten years. How soon can you buy a home after a bankruptcy? It depends on the type of bankruptcy, the loan program and the lender, but you can expect a minimum of two years in many cases.
Collection accounts, loan defaults, repossessions and other negative information remain on your credit report for a minimum of seven years.
In addition to bankruptcies, other derogatory items are found on your credit report, such as past due accounts, accounts in collection, loan defaults, debt settlements, repossessions, and foreclosures. These items have a negative impact on your credit score and remain on your report for a minimum of seven years, in most cases. Lenders will review this information carefully. Like a bankruptcy, how this will affect your loan application depends on the lender and their guidelines.
A credit inquiry is generated each time you complete an application for a credit, whether to acquire a credit card or to purchase a product or service. Inquiries are also created when you apply for a loan — personal, auto, student, or home loan. Opening a number of accounts in a short period of time can lower your credit score, but this varies from one person to another. In contrast, if these inquiries are related rate-shopping for a mortgage or other type of loan, they will often be ignored in the FICO score calculation.
This section lists the addresses for you that were reported to the credit bureaus, both current and prior ones. Although this is often a small section of your report, it is an important one. Your lender will carefully review this list to confirm the addresses listed match what you provided on your application. A missing address could indicate you have ownership in another property and possible debt associated with it.
Letter of Explanation (LOE)
When you apply for a home loan, your lender will give you an opportunity to explain any issues they found on your credit report. This is done through a Letter of Explanation (LOE). The best LOEs are simple and concise. They can be used to correct minor reporting errors, such as discrepancies in your name and address. In addition, an LOE can provide details and an explanation of a more serious credit issue, such as a collection account or bankruptcy. Documentation that supports your explanation is helpful when provided along with your LOE.
Factors That Negatively Affect Your Credit Score
Poor Payment History
Your payment history is the largest component of your credit score. Lenders want to see that you pay your bills on time. A single late payment of 30 days may not affect your credit score, but a pattern of late or missed payments will. Overdue accounts, collection accounts, debt settlements, repossessions, foreclosures, tax liens, civil judgments, and bankruptcy hurt your credit score. In most cases, this negative information is reflected on your credit report for a minimum of seven years. In the case of a Chapter 13 bankruptcy, it is extended to ten years.
Having a poor payment history doesn’t necessarily mean you won’t qualify for a loan. It depends on what the lender finds acceptable. If credit is offered to you, it may be at less favorable terms and at a higher interest rate.
High Credit Utilization
Individuals who have maxed out their credit cards are perceived as higher credit risks. Having a high credit utilization ratio can hurt your credit score. Your credit utilization ratio is how much of your available credit you are using. To get this ratio, take the total balances on your credit cards and lines of credit and divide by the total of their limits. It’s often recommended that you keep this percentage below 30%. For example, if your total credit card balance is $3,000 and your limits total $10,000, you are utilizing 30% of your available credit.
Too Little Credit
On the other hand, having too little credit can also lower your credit score. Generally, a minimum of one bureau reported account, open for at least six months, is needed to calculate a FICO score. However, a lender will likely want to see more, a minimum of three active trade lines — credit cards, lines of credit and loans — on your credit report. The lender is looking for a history of you managing your debt successfully. Not having accounts that can prove your payment history can adversely affect your ability to get credit. However, opening numerous accounts at once is not recommended.
Opening/Closing Trade Lines
Because new accounts offer very little payment history and are often viewed as a risk factor, they have the potential to lower your credit score. When possible, you should avoid opening new trade lines at least six months prior to applying for a mortgage. In addition, closing credit cards and other trade lines with a good payment history before applying for a home loan can be a mistake, too. Trade lines, especially older ones, can help boost your credit score as long as there’s been some activity on them in the past year or two.
Correcting errors on your credit report before applying for a loan can save you time and help you avoid added stress.
Steps to Take Before Applying for a Loan
Reviewing your credit report to identify and correct errors can increase your chances of being approved for a home loan and other forms of credit. It may also improve your credit scores and allow you to qualify for the best loan terms possible. Because the process can take some time, do your review well ahead of your application for a loan, rather than during the approval process.
Get a Free Credit Report
It’s important that your credit report be accurate since it plays such a big role in your ability to get credit. You are entitled to a free credit report every 12 months from each of the three credit bureaus. The Federal Trade Commission (FTC) provides a link on their Get My Free Credit Report page to AnnualCreditReport.com which is the only authorized website for free credit reports. For individuals who prefer to call, a phone number is also provided. You will be asked to provide your name, address, Social Security Number, and date of birth, regardless of the method you choose.
Resolve Inaccurate Information
If you find errors on your credit reports, there is a process to correct them. Generally, the process involves notifying the credit bureau and the reporting company in writing. After receiving notice of the disputed information, the reporting company must investigate and report back to the credit bureau. If the disputed information is confirmed to be inaccurate, the reporting company must notify all three credit bureaus so your information can be corrected. The FTC is an excellent resource for detailed information on Disputing Errors on Credit Reports.
It may not be glamorous, but keeping a watchful eye on your credit report can help you reap the benefits of a high credit score.
A high credit score and strong credit history can open the door to a number of opportunities, including buying a home. They provide proof to lenders that you can be trusted to pay your bills and manage your debt successfully. You have the opportunity to improve your credit scores by removing inaccuracies, maintaining a credit utilization ratio of 30% or less, and keeping your trade lines within a manageable level. Reviewing your credit report before applying for a loan can save you time and potentially result in a better interest rate and terms. By being attentive to the details behind your credit score, you can use it as a tool to meet your current needs, unlock future opportunities, and build a more secure future.
If you are ready to explore home loan options, you can rely on the mortgage professionals at Axos Bank to tailor a program to meet your unique needs. Call 888-546-2634 to speak with an experienced mortgage specialist today.
FICO® is a registered trademark of the Fair Isaac Corporation in the United States and other countries.
Home Loan Basics: Credit Considerations
This blog post was published by Axos Bank on July 9, 2019 and last updated on July 11, 2019.