Understanding Credit Reports and Credit Scoring
As a mortgage lender, when it comes to granting credit, the underwriter will look at various components of the file and make the credit determination on whether a particular applicant meets certain risk guidelines. One of the areas the underwriter will focus on is what is referred to as credit character or financial character to determine whether an applicant handles their debt properly and thereby is the applicant a good risk to grant new credit.
Much of what the underwriter looks at is what is called credit scoring. Credit scoring is not a determination of a persons' credit character. Instead, credit scoring is a risk indicator. It's a tool the underwriter uses to determine if granting credit to an applicant is reasonable. The credit scoring process is a long algorithm, a mathematical formula that establishes a number that represents the risk of granting credit. The credit score model was developed in the 1960's for various types of creditors but has only been used in the mortgage industry since the early 1990's. Depending on the credit bureau, Experian, Trans Union or Equifax, credit scores range between 300 and 850. The mortgage industry is not the only credit score model or system. Different credit score systems produce different credit scores. Credit card companies, for example, use a different credit score system which is derived from the same credit bureaus, but with a different credit score algorithm or credit score model. This is also the case with the consumer credit score that you would see from a source such as freecreditreport.com will produce a different credit score. Because of this, credit scores on the same individual can differ significantly depending on what kind of creditor pulls the credit report. These different systems are utilized for different kinds of credit, which makes sense because car credit is different than mortgage credit. This can be confusing to the average consumer especially when their score comes back lower than what they anticipated. From our experience in the mortgage industry, credit score range between 460 and 820.
There are 3 credit repositories, which are often called credit bureaus:
Equifax – Beacon
Trans Union – FICO
Experian – Fair Isaac
Each of the credit repositories or credit bureau's use a different credit score model. Equifax uses the Beacon model, Trans Union uses the FICO model and Experian uses the Fair Isaac model. Each of these models often produces similar scores, but sometimes can be quite different. This, in part, is because not all creditors report to all three bureaus and therefore do not utilize the same data. Some creditors will report to one bureau, some two and some will report to all three. As such, different credit score models in conjunction with different data sets will produce very different credit score numbers. Most mortgage lenders will require a tri-merge report which is one report from each bureau merged into one report. The lender, for qualifying purposes will utilize the middle score. If there are only 2 scores available, the lower score will be used. Historically, Trans Union often produces the lowest score, but not always. Part of mortgage loan underwriting is determining an individual's credit worthiness. This is the individual's ability and track record of repaying a debt. The willingness to repay a debt is indicated by how timely past payments have been made to other lenders. Mortgage lenders use the credit report to view an individual's credit worthiness. Additionally, mortgage lenders use credit scoring as a measure of the individual's credit risk.
What Goes into a Credit Score?
What goes into credit scoring? There are a number of variables, one of them is the amount and age of credit card tradelines, the number of loan tradelines i.e. mortgage, installment or any closed end loans, tradeline seasoning or the age of the tradelines, the length of time since the last late payment; in order to be considered late, it must be greater than 30 days. The number of tradelines; dollar amount, type and age of any derogatory tradelines; collections, judgments as well as public record accounts. The number of open revolving accounts i.e. lines of credit and credit cards are the most common. Also, the amount of available credit on your revolving accounts, dollar amount as well as the percentage of available credit. When applying for credit, try to pay down your credit card debt to below 30% of the available credit amount on that account before you have your credit pulled. Depending on the credit bureau, there are between 30 and 50 different areas that are analyzed in producing a credit score.
To summarize, it's about delinquency, credit balance to available credit ratio, lack of credit, type of credit and the number of inquiries. The ideal credit profile is two mortgages, two installment loans and three to five revolving or credit card accounts.
The Major Factors or Components That Make Up Credit Score:
Payment history represents between 30% and 40% of the credit score criterion. This includes the number and age of any collections and judgments. One 30-day late within the last 12 months can reduce your score up to 100 points.
The availability of credit and the over-all utilization:
- Amount and age of tradelines:
- Average balances on each tradeline or all tradelines as a whole
- Balance to credit limit ratio on revolving accounts
The number of tradelines and over-all utilization represents between 30% - 35% of the credit score criterion.
These 2 components represent between 60% and 75% of the credit score model.
Credit Inquiries and Account Seasoning:
Age of Credit History. The oldest tradeline, newest tradeline and average age of all tradelines. The oldest tradeline is important as well as the number of accounts that were opened with in the last 12 months.
Excessive and recent inquiries can reduce a score as much as 10 to 30 points.