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The Credit Score

This page covers the basics of FICO® credit scores.  Credit scores are calculated by evaluating Payment History, Amounts Owed, Length of Credit History, New Credit, and Types of Credit Used.

Most consumers have a Credit Report that is pages and pages long. In addition to the length of the credit report, there is a lot of variation from person to person in terms of what appears on the report. It was clear that having a way to evaluate consumer’s creditworthiness in an easier way would be of great use to many creditors, employers, landlords, insurers, lenders, etc. FICO did just that, but generated a number to represent a consumer’s creditworthiness. We call this number the Credit Score.

What is FICO?

FICO: Fair Isaac Corporation. It is a publicly traded corporation that provides software that utilizes information in a credit report to calculate credit scores.

There are a number of different credit scores available, but FICO scores are used by over 90% of creditors in the United States.

FICO calculates 49 different credit scores. The different scores are designed to suit different needs. For example, the score used to assess if a consumer should be granted a $500 store credit card is different than the score used to decide whether a consumer should be granted a car loan. Each credit reporting bureau has its own method of calculating scores (although they are fairly similar to one another). The way scores are calculated is also updated frequently, so it doesn’t take long for the different scores to become available.

The basic FICO® credit score is the one most frequently used, especially by credit card companies. This is also the score that consumers see if they request a credit score.

This score ranges from 300 – 850, with 300 being high risk/poor rating, and 850 being low risk/excellent rating.

More specifically, the scores are grouped into ranges for Excellent, Good, Average, Poor, and Bad as follows:

720 – 850: Excellent

It is estimated that slightly less than 50% of the population has an excellent credit score. This is a group of people who have generally been at their current job (or current line of work) for more than 2 years. These people pay at least the minimum payments on their debts on time every month. These people generally carry a balance of less than 30% of their available revolving credit (i.e. credit cards), and they do not open new credit accounts frequently, or have many credit inquiries.

680 – 719: Good

This group contains approximately 15% of the population. These people may be doing almost everything right, but have a lower score because of one or more minor issues. Perhaps one of their credit cards has a high balance, or they were late on a payment in the last 2 years.

620 – 679: Average

It is interesting that this group is called average. About 65 – 80% of Americans have better credit scores than people in this group. Opening new credit accounts is often the cause of the downfall of this group. Perhaps these people like to save 15% off their first purchase at a department store, or they wish to take advantage of low introductory rates for balance transfers on credit cards. These people may have large debt loads from car loans or student loans. They may also have too many credit cards and/or have high balances on those cards. Being late or missing minimum payments may also contribute to these lower scores.

580 – 619: Poor

This group contains about 10% of Americans who are likely affected by a  combination of the factors listed in the “Average” category. This group of people may have a difficult time obtaining credit for car loans and mortgages.

Below 580: Bad

This group is comprised of the bottom 10% of the population. This group is likely affected by a combination of the factors described in the “Average” group, plus a foreclosure or bankruptcy on their report. Most credit issues can be cleaned up over time, however, foreclosures and bankruptcies tend to damage credit scores for many years, if not permanently.

Luckily for most people, it is possible to increase a credit score with a few easy steps. Some credit scores can go up quickly, while others may take a little more time to resolve. We will cover these steps a later, but first it is useful to know WHY we may want to increase our credit scores.

How Do Credit Scores Affect Consumers?

Credit scores affect consumers in a number of ways. Landlords, employers, and creditors frequently look at these scores for their current and potential customers. Having a favorable credit score could mean the difference between being offered desirable rental housing, a job, or a loan… or not.

For the real estate licensee, a buyer’s credit score can be crucial to determining which properties the buyer can afford. Credit scores can affect the loan amount, interest rates, required down payments, and whether or not a potential buyer can be approved for a conventional mortgage.

The following example was taken from www.myfico.com and reflects 30 year fixed mortgage rates on a $300,000 loan based on Jan 31, 2014 market rates.

Example:

$300,000 loan, 30 Yr fixed mortgage

FICO® score APR Monthly payment
760-850 3.917% $1,418
700-759 4.139% $1,456
680-699 4.316% $1,487
660-679 4.530% $1,525
640-659 4.960% $1,603
620-639 5.506% $1,704

As can be seen here, a borrower with a poor credit score would pay $286 a month more than a borrower with an excellent credit score on a $300,000 loan! National averages demonstrate that lenders may charge more than 1.5% additional interest as a risk premium to individuals with lower credit scores.

What if a married couple is applying for a mortgage loan together? What if one spouse has an excellent score, and the other has an average score?

If two individuals are applying for a joint mortgage loan, which credit score will be the one used to calculate the interest rate?

  1. The higher score
  2. The lower score
  3. An average of the two scores
  4. Neither score, as mortgage rates are the same for all borrowers

As a buyer, you are probably hoping that a) is the correct answer, but have a feeling that b) is the correct answer. Mortgage lenders have become much more risk-averse over the last few years. They will generally weigh the lower credit score more heavily and base their mortgage rates on the score that is the lower of the two.


Mortgage Interest and the Debt to Income Ratio

Staying with the above example, we know that lenders base their pre-approval amounts on the debt to income ratio:

Minimum Monthly Payments on Debt ÷ Monthly Gross Income = Debt to Income Ratio

This critical ratio shows the borrower’s ability to take on more debt. Mortgage lenders generally will not lend more than what would constitute 28% of a person’s monthly gross income. If there is other debt, mortgage lenders will generally not originate a loan that causes a borrower’s total debt to income ratio to exceed 36% (mortgage plus other debts).

As shown in the table on a previous page, a person’s monthly mortgage payment on a given property can vary dramatically based on their credit score. The borrowers with higher credit scores are charged a lower mortgage rate, which means their monthly payment is lower for any given loan amount.

People with a FICO® score above 760 can borrow up to $360,000 and have their monthly payment be the same as an individual with a FICO score below 640 who borrows $300,000.

In other words, people with better credit scores can borrow more money with a lower interest rate than those with less desirable credit scores. People with excellent credit scores may be able to afford a more expensive property than those with the same income, but lower credit scores.

In addition to that, banks may require larger down payments for those individuals who are seen as a credit risk. If a borrower’s credit score were improved, they may be able to borrow more money for a lower interest rate and less money down on a property. Taking a few steps to improve a credit score can be well worth it!


Anatomy of a Credit Score

Now that we see how important credit scores are to real estate borrowers, you may be asking how these seemingly magical credit scores are calculated. The simple answer is that no one knows exactly how they are calculated. The credit bureaus and FICO® keep that information top secret, like the formula to Coca Cola, or what’s in the Special Sauce on a Big Mac. We know what the ingredients are, we just don’t know the precise amounts of each.

This is what we do know:

Source: www.myfico.com

When looking at these categories, keep in mind that the last 2 years (24 months) is the most critical period of time. Information dating back many years is kept on a credit report, and foreclosures and bankruptcies can damage credit from anywhere between 7 years to permanently. For most credit events, the previous 24 months is the period of time that is used in order to calculate a credit score.

Payment History: 35% of Credit Score

This category is weighted the most heavily and includes items such as:

  • Did the amounts paid at least cover the minimum monthly payments?
  • Are accounts up to date?
  • Were there “slow pays”? (payments past due dates)
  • Were there missed payments?

With revolving credit, the minimum monthly payment must be paid on time each month. Unlike some loans, borrowers cannot make a double payment one month and then skip the next. If a consumer is not able to make the minimum monthly payment on time every month, it is a good idea to call the credit company and try to set up a better payment plan.

Amounts Owed: 30% of Credit Score

“Amounts owed” is a complex set of criteria. The actual dollar figure owed is only one facet of this portion of the credit score. While the total amount owed is certainly important, a critical component of this category is the Credit Ratio. Simply stated, credit ratio is the credit balance divided by the credit limit:

Credit Balance ÷ Credit Limit = Credit Ratio

For example, if a consumer had a $5,000 credit limit and held a $2,000 balance, their credit ratio would look like this:

2,000 ÷ 5,000 = .4, or 40%

Credit Ratio                                      Risk      
< 30%                                                Low (ideal)
30-49%                                              Medium
50-75%                                              High
100% or more                                  Very High

What if a consumer has more than one credit card? What if the credit card does not have a pre-set limit? What if the consumer has “maxed out” one credit card, but has zero balances on other cards?

These are common questions that are difficult to answer without knowing the exact formulas used by the credit reporting bureaus. Many experts deduce that not only does the overall credit ratio matter, but also the individual credit ratios.

For example, if a consumer has a retail account for a local department store that has a ratio of 95%, it could significantly impair a credit score. Even if the credit limit for this one account is $500, the consumer would have a total of $25,000 of available credit and an overall credit ratio of 10%.

It is unclear how having credit cards with no pre-determined limits affects these ratios. They do factor in, but it is hypothesized that the current balance may be used as the credit limit in calculating credit ratios.

Some people may wish to reduce the number of open credit cards and cancel some they no longer wish to use. Consumers should be careful about closing accounts that have positive balances. If such an account is closed, then the credit limit immediately goes to $0, which will affect the credit ratio, making it appear that the consumer is over their credit limit on that account.

Another important factor is the number of open accounts.

Saving 10% or 15% off a purchase for opening a retail credit card may sound beneficial; however, doing so hurts credit scores. Having a small number of accounts can help to build a credit history. Having more than 3-5 open accounts shows that the borrower may be a serious credit risk. Even if the open accounts have small to zero balances, too many open credit accounts is harmful to a credit score.

Length of Credit History: 15% of Credit Score

How long has the consumer had credit accounts? How old is the average account? How old is the newest account?

If a consumer frequently opens and closes credit accounts, it is detrimental to their credit score. To optimize this category, credit accounts should be 5 years old or older. Taking advantage of an introductory credit card offer to transfer balances may save money, but it could hurt a credit score.

Consumers may need to take out new loans to buy a car or finance dental braces that require new accounts to be opened. If at all possible, consumers interested in maximizing their credit score are better off attempting to keep long standing credit cards open, rather than ditching them for new accounts. More about new credit cards is covered in the next section.

Rather than rushing to open a new credit card with a low introductory interest rate, try calling credit card companies that have open accounts to negotiate interest rates. It has been estimated that credit card companies pay hundreds of dollars on average to acquire new customers. Companies may be willing to go to great lengths to keep existing customers! A quick phone call may result in a reduced interest rate, or even matching a 0% balance transfer offer!

New Credit: 10% of Credit Score

This category not only includes new accounts, but also includes number of credit inquiries, even if no new account is opened.

Some of the more popular ways people unknowingly hurt their credit scores include:

  • Opening up retail store credit to get introductory offers (like 10% off first purchase)
  • Shopping around for loans on homes or cars
  • Mailing in “pre-approved” credit offers
  • Applying to rent numerous apartments that request a credit check (landlords must obtain written permission before pulling a credit report)

Any time a new credit account is opened or a credit inquiry occurs, a consumer’s credit score is reduced.

Types of Credit Used: 10% of Credit Score

This category is a delicate balance (pun intended). In order to maximize a credit score, the consumer should have experience with a diverse mix of the different types of credit, but they should not have high balances in any one account, or overall.

The types of credit available include: Revolving Credit, Installment Loans, Finance Company Accounts, and Mortgage Loans.


Specific Events that Reduce Credit Scores

Many extremely responsible people have credit scores that may not accurately reflect their credit worthiness. We may unwittingly do some of the following things that may ultimately hurt our credit scores:

  • Open new credit card accounts to transfer balances to lower rate cards
  • Close old accounts so that the average age of open accounts is less than 5 years
  • Apply for a few loans, hoping to shop around for the best rate
  • Open retail credit accounts to receive discounts
  • Keep overall credit balances low, but have one account with a high credit ratio
  • Close a credit card account before paying off the balance in full
  • Have many open credit accounts – even if they have zero or low balances
  • Not making payments on time: skipping a month, paying late, or paying less than the minimum monthly payment
  • Allowing a disputed charge to go to collections, rather than correcting it

Specific Actions to Improve a Credit Score

Specific Actions to Improve a Credit Score

  • Make at least the minimum monthly payments on time every time.
  • Do not let credit accounts go to a collection department or be sold to a collection company.
  • Limit the number of open credit accounts to between 3 and 5 accounts.
  • Keep credit balances low (or zero) on all open accounts.
  • Try to keep old credit card accounts open.
  • Keep credit inquiries to a minimum.
  • Do not close credit accounts until the balances are paid off in full.

Debt to Income Ratio

Debt to income ratio looks at monthly debt and compares it to monthly income.

For debts, lenders want to know:

  • Mortgage payments, including principal, interest, property taxes, mortgage insurance, homeowners insurance, association dues, etc.
  • Credit card debt
  • Installment loans such as student loans, health care loans, and personal loans
  • Finance company accounts (no interest furniture loans, for example)
  • Car loans
  • Child support payments

Taking the minimum payments for these obligations per month is the debt part of the equation.

For income, lenders will look at gross monthly income. This is income before taxes and benefits are withheld. In the case of variable income, a lender will likely ask for a profit and loss statement for the year to date. They will also want to see the last 2-3 years of income to get a sense of how the income averages out over time. If a person has a volatile income and has not been in the same occupation for a couple of years, lenders may become very conservative about what they will count as monthly gross income.

The debt to income ratio is just that:

Debt to Income Ratio = Total Debt / Total Income


 

Front End Ratio

Front End Ratio – this is also known as housing ratio. This is your housing debt to income ratio. Housing debt is also known as a PITI payment (PITI = principal + interest + taxes + insurance). This ratio does not look at other debt, it is just the front end, or the housing part.

Front End Ratios may not exceed 28% for conventional mortgages 

Example:

The Harrisons have $10,000 in Gross Monthly Income (their income before any taxes or other deductions are taken out – their actual paycheck will likely be much less).

What can the Harrisons afford?

If we multiply both sides of the equation by 10,000, we get:

X = 2800

The Harrisons may not be approved for a mortgage loan in which the PITI payment exceeds $2,800 per month.

What that means in purchasing power depends on the current interest rates, the local property tax rate, mortgage insurance, and homeowners insurance. The amount the Harrisons will be approved for will vary over time and across different locations.

Back End Ratio

Back End Ratio – this is the total debt to income ratio, which includes the housing debt AND other debts owed for at least the next 10 months by the borrower.

Back End Ratios may not exceed 36% in most cases. Some Qualified Mortgages may let the Back End Ratio be as high as 43%.

If the buyers have $1,000 worth of other debt (car loan, student loan, credit card, etc.), how much can the buyers afford?

 

 

If we multiply both sides of the equation by 10,000, we get:

X + 1000 = 3600

Next, let’s subtract $1,000 from both sides:

X = 2600

When the other debt is taken into consideration, the buyers can afford a home with a PITI payment of $2,600.

For most buyers, going up to a 36% debt to income ratio is not comfortable!

43% back end ratio is difficult, even for the most frugal purchasers.

The temptation may be great and buyers may want to go for a 43% back end ratio. What would that look like with our current example?

 

 

If we multiply both sides of the equation by 10,000, we get:

X + 1000 = 4300

Next, let’s subtract $1,000 from both sides:

X = 3300


What is a Buyer to do?

The combination of high debt, low income, and a fear of real estate creates challenges for the average buyer, especially first time home buyers. It is a good idea for anyone with these credit issues to consult a qualified credit counselor. State government websites are good places to find reputable government and nonprofit agencies for this.

Some basic advice that applies to most potential buyers is:

  • Pay down credit card debt. Pay off the highest interest debts first.
  • Save as much down payment as possible (after paying down debt).
  • If family members wish to give their favorite home buyer a gift, perhaps it is best directed at paying off debt, rather than going towards a down payment.

Paying down debt not only improves a debt to income ratio, it relieves some of the burden of the expenses first time homebuyers may not expect. Another benefit is that mortgages usually have lower interest rates than credit cards. The interest payments are tax deductible for mortgages, but not for credit card interest payments.