This is the most important chapter in this book. Whether you are purchasing a home, a car, or a refrigerator on credit, your credit profile will play a significant part in determining your ability to qualify.
Let’s start with the basics. When you obtain credit, you do this from what is called a creditor. You are the debtor. Creditors of all types, report your payment information to what are called credit bureaus. There are three of them, and you have probably heard of them. They are Experian, Equifax and TransUnion.
These credit bureaus collect data from a variety of creditors, from banks, to finance companies, to utilities, to landlords in some cases. What they do with this data is to put it into a scoring model.
This scoring model weighs different factors, and generates a credit score. When you have your credit pulled by your lender, they will use what is called a credit reporting agency, or CRA.
The CRA will go to each of the three bureaus, pull data from them, including the scores they came up with, and prepare the credit report that you and your lender see.
All three bureaus use the same scoring model in calculating your scores, so in a perfect world, they would all calculate the same score. Sometimes though the bureaus get information from different creditors at different times, if ever, meaning that scores will vary from bureau to bureau.
Your lender will take the middle of the three scores to arrive at what they will use as your “credit score” in qualifying you for a mortgage. Credit scores can range anywhere from the mid 300 to the mid 800 range.
If you are looking to purchase a home, of course the higher the score the better, and most lenders are looking to see borrowers with a minimum of 620. Anything lower and you are going to be moving away from what is considered traditional financing.
Factors That Affect Your Credit Score
While there are many factors used in determining your credit score, including how long you have had credit, and the type you have, there are two that you need to be particularly aware of. They are recent late payments, and balance to limit ratios. They make up a significant part of the scoring model
Recent Late Payments
Lenders like Maureen, want to know that you are capable of paying your existing obligations on time before they decide they want to provide you with even more. By recent late payments, we are talking about those in the previous one to two years.
Life events do come up that cause payments to be late. These include unexpected job status changes, and medical issues. Whatever the case, your lender wants to hear from you, both as to what happened, and why they can expect that it is unlikely to happen again.
Balance to Limit Ratios
This refers to the balance of a credit account, typically a credit card, in relation to the limit on it. A credit card with a $700 balance and a $1,000 limit, for example has a ratio of 70%.
The credit bureaus ideally like these ratios to be 30% or less. Anything higher and these ratios start weighing on your scores.
If the ratios are too high, even if you are making the payments on time, your lender may get the impression that you have too much debt on your plate and are overextended. These ratios wouldn’t apply to installment debt by the way.
Thoughts on Having No Credit
There are schools of thought that say that credit is evil, and the less of it they have the better. While this is good in some respects, purchasing a home wouldn’t be one of them. Credit is a living breathing thing, and needs to be tended to over time.
Both the credit bureaus and lenders want to see that you use it regularly, to demonstrate that you are willing, and able to pay it back. If you have no credit, you will ultimately have no credit scores. This does happen, but credit is able to be built over time.
While building credit can take time, there are some good places to start. One is to apply for lower limit credit cards such as those from gas companies or department stores. You will then work your way up to traditional credit cards that are accepted everywhere.
Another option is to go with a secured credit card. This is where you give the issuer of the card the entire balance, say $500, up front. As you use the card then pay it back each month, you are building a credit history.
This alone could dramatically improve your scores, especially over time.
If you really don’t have any credit, but have an extended history of paying bills on time, you may be able to use what is called non-traditional credit to help you. This is where you show proof of on-time payments such as cell phone bills, gas bills, etc., for at least two years.
Underwriting guidelines for non-traditional credit borrowers are a bit more stringent for traditional borrowers, but homes can be purchased this way.