Credit scores are used by lenders to measure the credit worthiness of borrowers. While there are several different companies that offer scores, the FICO, Fair Isaacson Corporation, is the model that is used most often.
There are five key components that determine the overall score or rating. The most emphasis, 35% of the overall score, is placed on payment history which reflects whether the borrower paid on time and as agreed by the terms of the credit. Being late, missing payments or going into default would have adverse effects on this part of the score.
The second largest component, 30%, is credit utilization or the amount owed in relation to amount available. A person might have a $4,000 outstanding balance on available credit of $20,000. This would be a 20% ratio and would be considered acceptable. Owing $15,000 on $20,000 of available credit would be a 75% ratio and would negatively affect this part of the credit score. FICO says people with the best scores average around 7% credit utilization.
The length of time each account has been open and the account’s activity determines 15% of the total credit score. By having a longer credit history, the credit provider has a better indication of the borrower’s long-term financial behavior. Having an open account without activity doesn’t offer a provider much information.
New credit and types of credit each account for 10% of the total score. New credit can adversely affect a score because it is a new obligation without history of how it will affect the borrower’s ability to repay all of their liabilities. Types of credit include both revolving and installment debt. A good mixture of each can indicate less risk for lenders.
The combination of all five areas make up the total score which lenders use to determine credit worthiness. Another confusing issue is that all credit scores are not mortgage credit scores. This particular score determines not only whether the lender will make a mortgage but at what interest rate.
The best place to get your credit score if you’re planning on purchasing a home is from a trusted mortgage professional. This person will be able to suggest things to improve your score if necessary. Buying a home is one of the largest investments in most people’s lives; it is really not a do-it-yourself activity.