While basic understanding of the "book smarts" within the mortgage industry will help you understand specific terminology, loan programs, and features, there is so much more you will need to know in order to make an informed financial decision.
My approach to providing education strives to further your understanding beyond the "book smarts" of the mortgage industry, and learn the valuable "street smarts" that will help you achieve the best possible results, while avoiding the most common pitfalls that non-informed Borrowers and Real Estate Professionals have experienced.
The Mortgage Street Smarts of Credit Scores:
Important Definitions:
- Consumers - people like us who borrow and spend money
- Creditors - institutions who lend money to Consumers (also referred to as Lenders and Banks)
- Credit Bureaus - the entities that keep track of all the credit reporting from Creditors...about Consumers. These Credit Bureaus issue Credit Scores based on a snapshot of the data received on any given day. There are 3 Credit Bureaus:
What is the "Golden Rule of Lending?"
The "Golden Rule of Lending" is simple...those with the gold make the rules. In this case, we're not referring to gold; we are instead referring to money. Creditors have the money, and quite simply...they make the rules on which Consumers get to borrow it.
Is borrowing money a privilege or a right?
Technically, we Consumers have a right not to be discriminated against based on factors such as Race, Religion, Gender, Creed, Marital Status, and other demographic characteristics. The Creditors however, have a right to discriminate against Consumers based on risk factors. These factors include Credit History, Cash-Flow, Assets, Equity/Down Payment, and other risk-based factors.
When all the smoke clears, the answer is simple...borrowing money from a Creditor is a privilege. The rule of thumb to consider is to always prepare yourself to look as strong "on paper" as possible. Remember, it is better to be able to borrow money and decide you do not need or want it, than it is to need or want the money and not have the ability to borrow it.
What are Credit Scores...and why do they matter?
Credit Scores are a major determinant of risk assessment by Creditors, and are used in nearly every decision on whether or not to a Creditor will lend money to a Consumer.
- Credit Scores are computed for Consumers (by the Credit Bureaus) and typically range from 300-850
- The higher the score, the less risky a Consumer is considered to be (therefore the goal is to maintain the highest Credit Score possible at all times)
- The Credit Score to aim for is a 740 or higher (although any score above 700 is considered good credit)
- Credit Scores from 680-740 can typically qualify a Consumer for approval...sometimes however the interest rates will be higher
- Credit Scores between 620-680 will often involve higher interest rates if an approval is even granted (the Creditor will want to see strong "compensating factors" for other Consumer characteristics such as Cash-Flow, Equity, etc.)
- Scores below 620 will make things difficult (maybe even impossible) for a Consumer to obtain new Credit (depending on the rest of the circumstances)
How are Credit Scores calculated?
The breakdown of how a Credit Score is comprised is listed below:
Payment History (35% of weighted score)
The goal of this section is simple...pay all of your bills on time! If you successfully achieve this task, you will maximize the scoring opportunity within this portion of your credit scoring.
If however, you fail to pay a debt on time, there are 3 different distinctions that the Credit Bureaus & Creditors will make when describing your late payment (a.k.a. derogatory payment):
Recency - how long ago was the late payment made?
Frequency - how often were late payments made?
Severity - how late were your payments? (i.e. 30, 60, 90+ days)
Of the 3 distinctions above, the one that has the greatest effect on your Credit Score is RECENCY (since it paints a picture of the financial momentum that a Consumer has at any given time)
Example:
**Consumer # 1 has 37 late payments reported on their Credit Report...but the most recent late payment was 4 years ago
**Consumer # 2 has a total of 4 late payments reported on their Credit Report...but they were all last month (and are currently "past due")
In this example, it is highly probable that Consumer #2 has a lower credit score (due to the fact that the scoring model will interpret the recent late payments to mean that something is currently wrong with Consumer #2...and therefore consider them a higher risk)
STREET SMARTS SUMMARY
1) Pay your debts on time
2) If you make a mistake, it will effect you
3) Time will heal these wounds eventually...don't give up once you make a mistake. Your credit score will improve over time if you start making "on-time payments" moving forward.
Amounts Owed (30% of weighted Score)
An important distinction to be made here is that there are 2 types of loans on the market (in terms of how repayment plans are contracted):
Installment Loans - refers to loans that are paid in equal payments over a fixed amount of months. Once all payments have been received over the term of the loan, the loan is paid in full. Examples of Installment Loans include:
1. Automobile Loans ($400.00 per month x 48 months = loan paid in full)
2. Mortgage Loans ($2000.00 per month x 360 months = loan paid in full)
Revolving Lines of Credit - refers to the ability to continually "charge up" debt within a specific "Credit Limit"...then make payments to "pay down" that debt (based on the amount used on any given month). Examples of Revolving Lines of Credit include:
1. Credit Cards ($10,000.00 credit limit with monthly payments based on the amount used during that period)
2. Home Equity Lines of Credit ($100,000.00 credit limit with monthly payments based on the amount used during that period)
This scoring section is focused solely on any Revolving Lines of Credit that a Consumer has (the typical focus is specifically on any Credit Cards). When the Credit Report is "pulled" a snapshot is immediately taken of the most recently reported balances from a Creditor about a Consumer.
The focus of this snapshot is to determine the "percentage of credit utilization" that is currently represented. In other words, what percentage of the Credit Limits is currently being used?
The following is an example of how important this concept is (yet how often this section of the Credit Scoring is misunderstood). Hint: this section constantly hurts Consumers who do not understand its significance!
Example:
**Mr. Jones has 5 Credit Cards, each with a $10,000 Credit Limit (total revolving credit = $50,000).
**Mr. Jones only uses 1 Credit Card...the current balance is $8,000 (the other 4 Credit Cards have a "zero balance" on them).
The question I pose to you is this: "Should Mr. Jones close the 4 Credit Card accounts that he does not use?"
This exact question was posed a few years ago during a Credit Scoring Seminar presented by an Executive of one of the Credit Bureaus. The audience in attendance consisted of 100+ Mortgage Originators. Shockingly, over half of the room answered this question wrong! Here is the answer, along with the explanation:
Answer: No. Mr. Jones should not close the 4 unused Credit Cards! Why you ask? Let's examine the facts:
**Mr. Jones currently has $50,000 in available credit (5 Credit Cards x $10,000 Credit Limits per card)
**He is currently using $8,000 of his overall available credit
**Therefore, he is using 16% of his available credit ($8,000 divided by $50,000 = 16%)
**If Mr. Jones was to close the other 4 Credit Cards, he would eliminate $40,000 in available credit
**He would now be using 80% of his available credit ($8,000 divided by $10,000)
**By utilizing such a high percentage of his overall available credit, Mr. Jones would be deemed a "Credit Abuser" under the scoring model, and would severely hurt this portion (which is 30% of his overall score!)
STREET SMARTS SUMMARY
**Whenever possible, try not to "max out" your Credit Cards (the goal is to use a maximum of 50% of your Credit Limit on any card ideally)
**Do not close out your Credit Card accounts!
a) If you do not intend on using them, keep them open anyway
b) If you do not feel confident in your ability to restrain yourself from using the card, pull out your scissors and cut the card into pieces (but keep the account open)
c) If you are paying an Annual Fee for your unused Credit Card, simply call your Creditor and negotiate a "One Time Courtesy" to waive your Annual Fee (you can do this each year if you want...the odds of getting the same person on the phone next year are about the same as you winning the Lottery 2 weeks in a row!).
d) Most importantly, be careful who you are getting your advice from! Every Mortgage Professional who suggested the closure of those "4 unused accounts" is potentially guilty of passing on bad advice!
Length of Credit History (15% of weighted score)
This section simply analyzes how long you have had each specific Credit Account (also known as a Trade Line).
NOTE: The longer you have your accounts, the more stable you are considered to be.
In the example above, Mr. Jones would have also significantly hurt an additional 15% of his Credit Score by closing his unused accounts (45% total once you count the 30% in Section 2). Can you imagine how bad those Mortgage Originator's felt who got that question wrong? Talk about giving your Clients bad advice!
STREET SMARTS SUMMARY:
Try to keep your Credit Cards open for as long as possible (remember: you are only hurting yourself when you close a Credit Card account...you are not hurting the Credit Card Company!
They are not going to go out of business just because you closed your account)
Do not worry about Installment Credit (i.e. Auto Loans, Mortgage Loans, etc.). Pay them off as you see fit, and as your budget dictates. There is no reason to keep a loan longer (and pay more finance charges) just to try to improve this portion of the Credit Scoring model!
Realize that when you acquire new Credit, you will temporarily be hurting this portion of the scoring model. You can decide if the ends justify the means (typically they do as long as you do not abuse the privilege of borrowing "new money" too often)
New Credit (10% of weighted score)
The real issue here is not the "New Credit" (since that is basically factored in as part of Section 3 above).
What this section really pertains to are Credit Inquiries made when a Creditor "pulls your credit report" (NOTE: When you pull your own credit report from a website such as www.myfico.com, this will not count as a Credit Inquiry)
The more often your Credit Report is pulled (i.e. the more inquiries you have), the more it lowers this portion of the Credit Scoring formula, so be careful not to inadvertently sabotage yourself by letting too many companie's pull your credit!
Each Creditor has a specific "code" that identifies them as a specific type of Lender (such as Mortgage, Automobile Finance, Credit Cards).
You are allowed to "shop around" within reason within a short period of time, and within a specific type of credit sought (i.e. Mortgages, Automobile Loans)
STREET SMARTS SUMMARY:
Be wary of how often your Credit Report is pulled, since it will have an effect on your Credit Score
Remember that you can still shop around (but don't get carried away when you do)
Types of Credit Used (10% of weighted score)
This portion pertains to the "mix" of specific Trade Lines (the types of accounts you have)
There are distinctions made between the amount of Revolving Lines of Credit and the amounts of Installment Loans that a Consumer has reported
The mere presence of Finance Companies can hurt this section (these are typically companies who offer "6 months same as cash" or other financing gimmicks...often associated with financing pertaining to furniture, audio-visual equipment, etc.)
STREET SMARTS SUMMARY:
Do not get too caught up in this section (there is a reason it was listed last). The general consensus is that you should shoot for about 4-6 Revolving Accounts and 1-2 Installment Accounts (while having no Finance Company loans) if you want to max-out this section
Of all the Credit Reporting Seminars I have attended, I have yet to hear the same recommendation twice about how to specifically max-out this section.
For more information on topics like this, please feel free to visit www.MortgageStreetSmarts.com (an educational resource for Borrowers, Real Estate Agents, and Financial Professionals)
