Your Credit Score is Your Golden Ticket to Financing Heaven
When it comes down to the business of lending, evaluating risk is everything. Put yourself in a creditor’s shoes for a moment. If you had money to lend, would you want to know the probability of someone repaying you on time with interest? Of course. You wouldn’t want to do business with someone who has a high risk of not paying you back, but you would love to do business with someone who has a history of paying on time and in full.
Credit scores are an important indicator that a lender uses to gauge the risk they are dealing with. This doesn’t necessarily mean that a bank won’t lend you money if you have a poor credit score, but they might lend you significantly less, and at higher interest rates, to make up for the risk they’re taking. You might be a bit worried now. Perhaps your credit score is not so enticing. No worries. In this article, we’ll talk about your options, and discuss some ways you can increase your credit score to improve your chances of snagging a great deal on your home loan.
What is a FICO Score?
Where do mortgage lenders get your credit score from, and how does a 3-digit score reflect your credit-worthiness? There are a few credit-scoring systems available, but the most well-known and commonly used one was developed by a data analytics company called Fair, Isaac, and Company, now simply named FICO. FICO scores are used by 90% of top lenders with basic scores ranging from 300 to 850. The higher the score, the better your chances of getting good terms when applying for a mortgage loan.
If you’re like most Americans, you probably have a credit history with a bank or credit card company. These institutions desire to make smart lending decisions, so they regularly send your financial data to a number of credit reporting agencies (CRAs) who, in turn, provide the banks and credit card companies with credit reports. Credit reports are compiled by three different agencies: Equifax, Experian, and TransUnion. FICO’s proprietary algorithm uses data from these reports to generate a credit score the lender can use for determining your overall credit risk.
What Does FICO Look For?
Your FICO credit score analyzes several variables from your credit report, and puts more weight on some things more than others. These variables include your payment history (35%), amounts owed (30%), the length of your credit history (15%), your requests for new credit (10%), and the different types of credit accounts you have (10%).
Keep in mind that some lenders don’t send your info to all three credit bureaus, and each bureau has its own system for storing data, so scores may differ slightly between them. On top of that, a mortgage lender’s FICO formula will differ from an auto lender’s, as there are FICO scores specific to each industry. So, even though you don’t have control over the lender’s decision about which score(s) they use, you do have control over the way you handle your credit.
According to MyFICO.com, an exceptional score is 800–850, a very good score is 740–799, a good score is 670–739, a fair score is 580–669, and a poor score is anything below 580. You can pay to access your scores at any authorized FICO score retailer like myFICO and Experian. Otherwise, you can get your score for free from your bank if they are part of the FICO Score Open Access program.
How Do Credit Scores Affect Your Mortgage Options?
There are many mortgage options available on the market for both good and bad FICO scores. Under a Freddie Mac and Fannie Mae “conventional” loan, for example, the minimum FICO score typically required is 620 with a 3% downpayment, while a Federal Housing Administration (FHA) loan requires a minimum score of 500 with a downpayment of 10%. If you’re a veteran, the Department of Veterans Affairs will cover you (VA Loan) with no minimum score or downpayment required, and if you’d like to live in certain parts of rural America, a USDA Rural Housing Loan also has no minimum requirements.
The above sounds pretty lenient, but that would not be completely true. Underwriters require a host of other things from you when deciding whether or not to approve you for a loan. The lender combs through your income, savings, and debt to get a good idea of your financial situation. All of these factors are analyzed before reaching an agreement.
A FICO score between 740–850 is considered the cream of the crop for snagging the best deal on your home loan. If your credit score is below 740, you might want to work on improving it if you want the best deal possible. However, as stated before, your credit score isn’t the only factor that a lender considers. So, if you have a score below that amount, but you have a stable income and little debt, it’s possible to get a great deal as well.
How You Can Improve Your Credit Score
Improving your credit score will increase your chances of getting a great deal on your mortgage. So, how do you do it?
1. Pay on time. You should already know that if you don’t pay on time, it will hurt your credit, but just because you pay the minimum amount due every month, doesn’t mean that your credit score will remain unaffected. In fact, your “credit utilization ratio” is an important factor in determining your credit score. This means you should keep your credit card balance low every month. To do this, make small payments each month, or pay it off completely if you can. You should keep your credit utilization rate below 30%. For example, if your available credit is $10,000, keep your balance at $3,000. If you’re behind on payments, ask your creditor if you can work out a more flexible payment plan.
2. Avoid applying for new credit cards too quickly. Taking on more credit in a short period of time means more risk to a lender because it implies that you are in trouble. Also, avoid closing unused credit cards, unless they have an annual fee or are relatively new. This is because your credit score is calculated using the length of time of your credit history and your utilization ratio. Keeping an old card with a zero balance is actually a good thing.
3. Check your credit report. You are entitled to a free credit report once per year from all three credit bureaus. Check for errors and discrepancies between them. Notify the credit reporting agencies when needed.
4. Diversify Your Investments. Your credit score is given a boost if your eggs aren’t all in one basket. The variety (or “credit mix”) of loans that you have signifies your financial health and ability to repay multiple debts on time.
Now that you know how your credit score affects your ability to get the best deal possible when shopping for a mortgage, you are now among the few people equipped with the basic knowledge to make smart credit choices. Remember: A high credit score is your golden ticket to financing heaven! Be sure you take it seriously.
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