Credit Scores 101
What Is Credit and Why Do You Need It?
Your credit is a reflection of your ability to manage debts over time and successfully repay them. Creditworthiness is conveyed to lenders and creditors through your credit report and individual scores. The most well known are Fair Isaac Corporation (FICO) scores, but other scoring models, like VantageScore, are rating you as well. Your credit scores will help determine if you can borrow funds and the terms you'll receive, so they are an important part of your financial picture.
How Does Credit Work?
Three main credit bureaus (Experian, Equifax, and TransUnion) gather information and use their proprietary algorithms to generate a numerical credit rating for you (ranging from 300 to 850). Their analysis takes into account five different factors: payment history, amounts owed, length of credit history, credit mix, and new credit. Certain categories are given more weight than others and it breaks down as follows:
- Payment History makes up 35% of your score, so making on-time payments to your creditors is the most important factor in your individual credit scores.
- Amounts Owed makes up 30% of your score and reflects the ratio of your balances to your available credit.
- Length of Credit History makes up 15% of your score and takes into account how long you have been building your credit.
- Credit Mix makes up 10% of your score, so having experience with different types of credit (installment, revolving, and mortgage for example) can impact your scores.
- New Credit makes up the remaining 10% of your score and reflects your most recent credit inquiries and establishment of new accounts.
Only certain types of accounts report credit information to the bureaus. Installment and revolving accounts are most likely to show up on credit, along with home mortgages, home equity lines of credit and auto loans. Monthly services like your phone or cable bill typically won't report any information, unless they become delinquent and are sent to a collection agency.
How Can You Monitor and Maintain Your Credit?
It takes time to build up your credit profile and increase your scores so you want to do everything you can to maintain a solid credit rating. Many credit cards now offer members a glimpse at their FICO scores as part of their services. To truly dig into your credit report and credit scores though, you will need to obtain a consumer copy of your entire report. Each year you are legally entitled to a full report from each of the three bureaus, free of charge. The site to visit is www.annualcreditreport.com. Check each report for mistakes, omissions, and errors.
The most important thing you can do to establish good credit and maintain it is to make every single payment on time for every account you have. This is especially true for revolving and installment accounts, but it also applies to medical bills and phone and utility bills. Delinquent accounts that get sent to collections can have a tremendous negative impact on your credit.
Credit isn't established overnight, so avoid opening up too many new accounts at one time. New accounts reduce the average age of your accounts, which is a determining factor for your credit scores. Consider maintaining just a few accounts, with a low level of utilization (below 30% of your available credit is best).
Once you have established credit accounts, keep them open and in use for as long as possible. This contributes to your length of payment history as well as the amounts owed categories on your credit report. The more credit you have available but not in use, the lower your overall utilization percentage.
Why Are There Different Credit Score Requirements for Mortgages?
Since different mortgage loan programs adhere to different sets of guidelines, you may see higher or lower credit score requirements for FHA, VA, and Conventional loans. These guidelines can be set by GSEs like Fannie Mae and Freddie Mac, or by the FHA and VA directly. There may also be differences based on your loan-to-value percentage, and whether the loan is a purchase or refinance. There are even programs available, like the non-credit-qualifying FHA Streamline, that don't have specific score requirements.
When you're ready to get started on your next home purchase or refinance, our mortgage professionals can help review your credit profile and guide you along the way.
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