Property Ownership: Understanding and Improving Credit Scores

It would be nice to buy a home entirely with cash. The transaction would be simple, and there’s only one dotted line to sign. Unfortunately, for many in California, this just isn’t feasible … at least, not any time soon. We debated waiting to buy a home until we can pay for it in cash (mostly because of the fact that I get sweaty palms every time I think about loans) but the trade-off was too great. Waiting to buy a home for cash would have taken us more than fifteen years, since we had to focus on paying down $500,000 student loans as well, which is equivalent in price to our most recent home purchase. That would be fifteen years of paying for monthly rent, which could be equivalent to fifteen years of paying down the mortgage. I ended up wiping the sweaty palms on my jeans, taking a deep breath, and choosing the latter. Meaning, I had to take on a new loan, at the exact same price as my student debt. *Deep breathIf it wasn’t for my husband, I am not sure I could cope with the thought. Reassuring hugs and “we-got-this” fist bumps go a long way.

While I can ignore the nervous sweat and the anxious breathing, there is one thing a buyer applying for a mortgage cannot ignore: their credit score. Credit scores can be supplied by different companies, the most commonly used being FICO, which stands for Fair Isaac Corporation. Each score is calculated by an elusive mathematical equation that evaluates many types of information with the patterns in hundreds of thousands of past credit reports. Simply put, they are trying to evaluate the risk that comes with loaning you money.

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Things to note: 

There are several categories that the FICO score considers, including your payment history, the amount you currently owe, the length of your credit history, any new credits you acquired, the types of credit in use, and the number of credit queries. Here are a few things to note, and then we will go in dept into each category.

  • A FICO score requires that at least one account has been open for six months of more, and at least one account has been updated in the last six months.
  • Although a score can quickly be lowered, it takes time to improve your score. If you are planning to buy a home, and your score is lower than 750, I would recommend starting to improve your credit score NOW. There is no quick fix to improving credit. In fact, quick-fix attempts may backfire. The best thing you can do is to manage your credit responsibly over a long period of time.
  • A score considers all categories mentioned above, not just one.
  • Everyone’s score is calculated a little differently. One category may have more emphasis when determining my score whereas another category may weigh more heavily in calculating someone else’s. It’s impossible to say how important each category is, because it differs from person to person, depending on the overall picture. Therefore, it is important to work on each of the categories. With that being said, the general rule for a majority of people is that the categories are listed in the order of importance, with the payment history usually being the most important and the number of new queries being least important.

With that, let’s get right into it!

Payment History

A good payment history shows the lenders that you will be reliable in paying back the loan. Your score will take into account:

  • Payment history on many types of accounts, including credit cards, installment loans, and finance-company accounts.
  • Public record and collection items, including bankruptcies, suits, wage attachments, liens, and judgements. Bankruptcies stay on your credit report for 7-10 years. A foreclosure, short sale, or deed in lieu of a foreclosure lower your score by about the same amount. These are considered serious delinquencies, so don’t expect to get a new mortgage loan with favorable terms for 5-7 years.
  • Details on late payments: Your score considers how late payments were, how much was owed, how recently they occurred and how many there are. For example, a 60 day late payment is not as damaging as a 90 day late payment. However, a 60 day late payment made one month ago affects your score more than a 90 day late payment made five years ago.
  • How many accounts show no late payments, which will help increase your credit score.

How to improve your score:

  • Pay your bills on time.
  • If you’ve missed payment, get current and stay current.
  • If you are having a difficult time making ends meet, get help. May I suggest a financial planner?

The Amount You Owe

Using credit accounts does not mean that you’ll be a bad borrower. However, using many credit accounts and owing a great deal in each one indicates to the lender that a person may be overextended and is more likely to make some payments late or not at all. Your score will take into account:

  •  The amount owed on all accounts and on different types of accounts.  The total balance on your last statement is generally the amount that is shown on the report. The score will also consider what types of accounts are being used.
  • How many accounts have balances. A large number can indicate overextension.
  • How much of the total credit line is revolving credit, meaning carrying a debt balance month to month. Those who are closer to maxing out on many credit cards may hold greater risk.
  • How much of the installment loan accounts is still owed compared with the original amount. Car payments are a great example. Even if you’ve been paying the monthly dues on a $10k car loan, if the majority has been going to interest, then you may still owe 80% of the car loan when you apply for a mortgage. Paying down installment loans at a quicker rate obviously looks good.

How to improve your score:

  • Keep balances low on all credit cards.
  • Pay off debt as close to 100% as you can.
  • Don’t close unused credit cards as a short-term strategy to raise your score. It won’t work, and it may even lower your score! Long established accounts show that you have a long history, which is good in the eyes of a lender.
  • Don’t open new credit card accounts that you don’t need. I am talking to you travel hackers out there. Put it on pause.

The Length of Credit History

In general, a longer credit history looks good to lenders. I remember when Mike was trying to apply for a car loan. He had no credit history, and had difficulty getting it. It blows my mind that being financially responsible and not having credit history is considered a bad thing by lenders. What a backwards world we live in. Unfortunately, when it comes to borrowing money, a credit history is considered a good thing. Your score will take a look at:

  • How long credit accounts have been established  – the longer “the better”. Also, the more diverse types of credits you’ve been managing, the more responsible you seem.
  • How long it’s been since you used certain revolving credit. For example, an inactive credit-card is given less weight in your credit score than active ones.

How to improve your score:

  • Don’t open a lot of new credit cards. Remember that new accounts will lower your credit score, even if it is temporarily.

New Credit You’ve Acquired

Any credit less than a year old is considered “new”. The score will consider:

  • How many accounts you have. It will especially look at how many of those accounts are new.
  • How long it has been since the most recent account was opened. 
  • How many requests have been submitted for credits. Typically, inquiries remain on your credit report for two years, although FICO only considers inquiries from the last year.
  • The length of time since lenders made credit report inquiries. FICO will ignore inquiries that are more than a year old.
  • Whether your recent credit history is good following past payment problems. Off course, your score will be improved after getting current and staying current.

How to improve your score:

  • When you search for multiple loans, do them all within a certain time period. 

Types of Credit in Use

Usually, this category does not bear much weight in the score, however, it can if there is not much other information on which to base a score. This score looks at:

  • The different types of credit accounts you have. They look to see if you have a mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Off course, this does not mean you should go out and get one of each!

How to improve your score.

  • You can open new credit cards but ONLY AS NEEDED. You don’t need one of every type. Plus you have to remember to manage them responsibly. Meaning, pay each credit card in full at the end of the month. Note that closing credit accounts does not erase them from your report.

Number of Credit Inquiries

Credit inquiries are defined as the requests that a lender makes for your credit score or report each time you try to apply for a new credit line. FICO takes this number into account. Here’s what you need to know:

  • Inquiries do not have a large effect on your score. Typically, this lowers the score by less than five points. That being said, there is a larger impact if you have a short credit history or if you have few accounts. Also, people with six inquiries or more on their credit reports are 8 times more likely to declare bankruptcy, something worth considering.
  • Many inquiries are not counted at all. The following are not counted, although they may appear on your credit report: orders made by you from a credit reporting agency, lender requests for your score in order to make you a pre-approved credit offer, and requests from employers.
  • The score looks for rate shopping. This is why I mentioned before that shopping around for a mortgage or an autoloan should be done at the same time. Multiple potential lenders may pull your credit report, even though you are only looking for one loan. The score counts multiple inquiries in a 45-day period as one single inquiry. Also, the score ignores all inquiries made in the 30 days prior to the scoring.

So there you have it! Trying to understand your credit score can be overwhelming. Score determination is muddled by the fact that each individual’s scores bear different weights for different categories. The most important thing to remember is that you want to prove that you have little risk for defaulting on a loan. So pay back debt, stay current, be responsible, and do this over the course of a long time period. And the best day to start is today.

Good luck!

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