When applying for a mortgage, or any other type of loan, you will be advised that you should have a good credit score. Credit reports and credit scores are often talked about in terms of real estate transactions, but few of us fully understand what they are and how they’re calculated. To be fair, it can seem fairly complex.
Understanding how a credit score works allows you to improve your own more effectively. Fortunately, once you break it down, it’s not so complicated after all! Although the exact formula for calculating a credit score is secret and depends on the company doing the numbers, some factors clearly weigh more than others.
Understanding a Credit Report
A credit report summarizes how you as an individual pay off your financial obligations, based on information both past and present. It can be used by lenders to get an idea of your borrowing habits and repayment history, and it protects them from borrowers who have a bad track record.
Your credit score is derived from your report and is basically the odds that you will pay back what you owe. It’s represented by a number between 300 and 850/900 (depending on who is calculating the score, either Equifax or TransUnion). The higher your credit score, the more likely you are to pay off your loan. In terms of mortgages, most lenders typically require a minimum credit score of 680.
How is Your Credit Score Calculated?
Your credit score is constantly being updated and changes frequently, and this is the main reason why improving your credit score is possible in a fairly reasonable amount of time. There are five factors that determine your credit score, which essentially look at what you do, and don’t do, with the credit you already have available to you.
This might just be the most important factor, as your credit history contains all the information regarding how you have repaid any credit you have already borrowed. Information is collected from all your credit products, from credit cards and auto loans to student loans and cellphone contracts.
Each account you have is shown separately on your report, where it is detailed whether you have paid as agreed. Late payments and how many missed payments you have are also listed, as well as any negative information in your public records, such as bankruptcy or liens. All the information in this section is chronologically ordered, with older entries having less impact on your score than more recent ones.
Next in line is available credit. This second section is especially important to lenders, as it details how much of your credit you’re using, and what is available. Essentially, it shows what you already owe and whether you have the finances to take on additional debt.
This figure is known as your credit utilization ratio and is represented as a percentage; if you’re regularly using less than 35% of your available credit, your credit score will be higher. On the other hand, if you frequently max out your credit cards, you can be seen as a higher risk to lenders, since you already have a lot of debt to pay off.
Length of Credit History
This third section records how long you’ve been actively using credit, and details both your oldest and most recent credit products. It’s useful for lenders to know that you can responsibly handle credit for an extended period. A borrower who has only recently started using credit will have a lower score than one who has been borrowing responsibly for several years. Most data, good or bad, will be cleared after 6 or 7 years.
The forth factor is represented by the number and type of inquiries made for your credit. Each time your credit report is ‘checked,’ your score may take a hard or soft hit. A soft check is nothing to worry about, and generally occurs when you or someone else takes a look at your credit report for non-lending purposes. On the other hand, a hard check can have a negative impact on your credit score, and occurs every time you apply for a new form of credit and a lender views your report.
If you have several hard checks, as a result of numerous new credit applications over a short period, it can signal financial difficulty. This will make new lenders wary, as it may seem as though you’re taking out more credit than you can afford.
The final factor looks at how many types of credit products you have. Generally speaking, a well-managed, diverse history will show lenders that you can handle a range of different credit options at one time.
However, looking at the types of credit you’ve taken out can also shed light on your spending habits, occasionally throwing up red flags. A consolidation loan can indicate that you’ve struggled to pay off debts in the past, while payment plans can show that you’re unable to save up for larger purchases. Despite this, unless your credit report is otherwise bare, this section is generally considered the least important.
Understanding your credit report enables you to more easily maintain a good credit score. Knowing exactly what looks good and bad to a lender puts you in a position of power, but the best practice is to never borrow more than you need and avoid maxing out any line of credit.