Your ability to qualify for any kind of financing, from auto loans to mortgages, depends on your FICO credit score. Most lenders will pull your credit report looking for just one key piece of information, your FICO score.
The FICO score is used to evaluate your ability to handle a particular line of credit or loan and to also calculate the appropriate interest rate for you. Depending on their institutional financial goals, some lenders may use your highest FICO score. Others will look at the middle score, or in some cases, only one FICO score.
For example, if you were applying for a credit card at a department store, they would run your credit profile (only with your signed permission, of course) and obtain your FICO score. If the store reports to only one of the three credit bureaus, and not all three, then the credit inquiry will only pull from that specific credit bureau. The credit card is either then opened or denied based on only that one specific bureau’s information, and thus uses only one FICO score in it's application process.
The credit system works much differently for mortgage applications. Banks and mortgage lenders report to all three of the credit bureaus (Experian, Equifax and Trans Union if you didn't know), so when you apply for a mortgage they would receive three different FICO scores. These three scores are calculated on the three DIFFERENT credit reports that the credit bureaus send to the lender. Since there are now three different FICO scores, mortgage lenders will only use the middle (or average) FICO score in this instance.
Also, depending on the type of financing you are seeking, whether it is for a new car, a credit card, or a home mortgage, your FICO score makes up a major portion of the decision making process. A lot of lenders will look at nothing more that your score in order to make their decision. Some companies will also flag your file for a recent bankruptcy or forclosure and repossession as well.
Your FICO score is really a "how well I pay my bills score" that consists of the following keys:
35% of your FICO score is based on your payment history. The key points being frequency of payments (read: whether it was paid on time), and most recent occurrences of non-payment. In other words, all late or completely missed payments will hurt your FICO credit score, but more recently missed payments will have a bigger effect on your score than older ones.
30% of your personal FICO score is based on credit utilization. This is calculated based on the balance of all your credit accounts in relation to the maximum credit lines available. Revolving credit lines (read: credit cards) are the most significant part of this score.
Just these two factors comprise 65% of your credit score! That is why I call it a "how well I pay my bills score".
15% of your FICO score covers your individual credit history. This is based on the number of years your credit has been established (the longer, the better). Having one account for 5 years with consistent payments will look better than 3 accounts all paid off and closed within 6 months.
10% of your FICO score involves what types of credit you have, and the mix of revolving credit inquiries (read: credit card applications). This does not include inquiries with no financial rating (Read: an inquiry from a potential employer).
As I mentioned earlier, there are three different FICO scores developed by the Fair Isaac Company, one from each of the three major credit bureaus. Experian uses the Experian/Fair Isaac Risk Model, Equifax uses Beacon, and Trans Union has something called Empirica. Consumers are likely to have a different score with each individual agency because each credit reporting bureau has its own set of reporting companies and there will be variations in the credit information that is sent in to them.
Your FICO score ranges from 300 to 850 and suggests a general credit profile such as:
FICO score of 720 and above
This is a great FICO score, and it suggests that the risk of you defaulting on your credit is very low. If the lender finds any exceptions in your credit report, they will most likely be waived and set aside. If there are any weaknesses in the underwriting your credit (such as not a very long history), your high FICO credit score compensates for that particualr weakness.
FICO score 660 to 719
This is good FICO score, and suggests that your risk of default is still relatively low. This FICO credit score indicates that your credit history is acceptable and most people fall within this range.
FICO score 620 to 659
This FICO credit score represents a certain amount of risk to the lender. The credit underwriter will more than likely consider you, but will investigate a lot further to check on some details. For example, whether you are self-employed, have a high loan to value ratio, have any cash reserves, or are exceeding normal debt to income ratios.
FICO Scores below 640
Anything below 640 is considered sub-prime. Your risk of default is very high, and you will need to present strong compensating factors to the lender before the underwriter would consider approving a loan. Most mortgage lenders will not approve you for a house without at least a minimum 640 credit score.
FICO score between 619 to 585.
The underwriter will consider approving a loan but that depends on your specific credit issues. You are now in the same class as an applicant with no previous delinquency and lack of sufficient credit history. Mortgage lenders are much more likely to see mortgage delinquencies rise if they loan money to a consumer with a FICO score below 620.
FICO score between 584 to 500
You will have to explain your credit history in writing, and will need to pay off most of your debts to even be considered for approval. The loan underwriter may still consider you an acceptable risk but the high risk factors your credit score presents will have a really high interest rate attached to a much smaller credit line.
FICO score below 500
This is really bad credit. There may be some serious issues outside your control that caused this financial setback, however. There are also some individuals who simply do not care about what happens to their credit score. This does not mean that the world has ended, though. There is still hope and a way to fix your score.
Additional Notes About Your Credit Score:
Your credit report changes each month and your FICO score will change as well. Your FICO credit score does not change drastically from one month to the next month, unless there has been a late payment or a negative report hit your account. While late payments, collections, or bankruptcies can be very damaging to your score, it simply takes time to raise your FICO scores back up. It is a good habit to check your credit report every 6 to 12 months.
Your credit report must contain at least one reporting credit line over a six month period in order for a FICO score to be generated at all. Your credit report must have one credit line that has been updated in the last six months as well. This will ensure that there is enough information overall, and enough recent information, to accurately calculate your FICO score.
Your FICO credit score is meant to be a measure of your creditworthiness to a potential lender. In the mortgage industry, mortgage products and lending terms change constantly. If you manage your credit well, you will certainly qualify for a home purchase loan. In the case of credit cards, your account is reviewed periodically (usually every 6 months), and if you manage your credit well, you will most likely be given higher credit limits and offers to upgrade to a better rewards program.
To quote Tracy Lawrence, time marches on...
It is important to notice that the current generation of younger people is getting involved with a lot of things that were either non-existent or simply not possible in the past. Today’s youth can write a text, talk to a friend, listen to a playlist of songs, update a social network page, and surf the Internet all at the same time from their "phone". When I grew up, we used a wall mounted phone to make "phone calls".
It should be fairly obvious that the younger generation has an entire world of opportunities within their reach. But along with these new and opportunities comes personal responsibility. Often, responsibility involves money and work. Today's generation needs to know how to handle their personal finances. That financial responsibility should be emphasized specifically for those getting ready to enroll, or are already enrolled, in a college or university.
Let's examine the case of an average college student. Their night begins at around midnight with either a late night out with friends, or a full blown house party. The next morning, reality kicks in with a hangover. All the money that was wasted on beef jerky and nacho chips, is now nothing but crumbs on the frat house floor. During the day there is class to attend, laundry to do, and papers to finish writing.
They probably went grocery shopping just 3 days ago, but all the food that was stocked up for the week is gone already. Now, here comes another trip to the nearest grocery store to restock the pantry shelves. What are they going to eat for lunch and dinner? They haven't even begun to deal with the real responsibilities. There are still payments to be made for rent, electricity, heating and water bills… wait. What about tuition?
In general, people have no problem spending more money even when they know there is no money left to spend. Even older, more mature, and supposedly more responsible adults fall into the same spending patterns. Why should we act surprised when our younger generation follows the same path we laid out?
The real problem is the lack of education being taught to younger generations, both from their adult parents and their circle of friends. The spending habits that you begin exhibiting early on in life carry through from childhood to adulthood. A teenager who spends sixty dollars on a "popular brand" shirt now will spend several hundred dollars for another "popular brand" shirt later on in life. These little "splurges" tend to stack up over time and become a huge financial crisis during one of life's many financial lessons. These "financial lessons" include divorce, job loss, credit card debt, or home and auto repossession.
It is much better for our younger generation to learn how money works before they graduate from high school. The earlier, the better! In the real world, where life consists of credit cards and mortgage payments, anyone who does not know how money works will end up in some sort of financial trouble. Young people should learn more about taking care of personal finances, while they are still young and able to change their course. The only problem that remains now is who is teaching them?
So you’ve decided to buy your first home. Perhaps you’re a newlywed, and you want to pursue the American dream. Maybe you’re a disgruntled renter, who is just tired of throwing away your hard-earned money every month on someone else's mortgage. Or perhaps you’re a savvy investor looking to turn a profit off the housing market while having somewhere to lay your head at night.
Whatever your reason for buying right now, you’re ready to go do it. Purchasing your first home can be a wonderful, weird, and sometimes intimidating experience to the average person; sometimes it is all those things at one time. By following a couple simple steps first, your transition into homeowner can be a smooth one.
Get Your Credit Straight
It can be tempting to start looking online and searching for the home of your dreams before you do anything else. Before all of that starts though, you have to get your credit in order first. The three major credit agencies who keep track of your credit - Experian, TransUnion and Equifax - will each have their own records and scores for you. Each agency has a credit score on file, and a record of all your debts and payments. Check each of these records independently. If there are errors on any of your reports, it could take a couple of months to correct them. Please take the time to handle your credit prior to house shopping.
Know Your Financial Limits
If you’re a first-time homebuyer, chances are pretty good that a lot of houses will be outside your financial capabilities. What you need to know before moving in is exactly how much house you can afford. The general rule thrown around is to purchase within a price range of about 2.5 times your gross household income. I disagree. I reccommend a payment of no larger than 1/2 of the smallest paycheck in the house. For a more detailed number, you can get pre-approved by a mortgage lender. Be forewarned, they will approve you for the largest amount possible, not what you can truly afford.
Have A Down Payment
The down payment is the toughest part of buying a house. Finding enough cash for a down payment, along with the closing costs (costs associated with buying a home, such as loan fees, appraisal fees, inspection fees, legal fees and title search fees) can be a real problem for a lot of soon to be homeowners. As a first time homebuyer, that’s not a small amount of money , especially when most lenders ask for 20 percent down so you avoid the PMI, or Private Mortgage Insurance. There are other options available though. Several private banks and public agencies offer programs where you can pay as little as 3.5 percent down on a home.
You will most likely have to pay private mortgage insurance (PMI) if you go this route. Mortgage insurance protects the bank in the event that you default on your new loan. PMI will add to your monthly payment.
Find Money For The Down Payment
If you’re just tapped out financially, and you need some quick cash to cover a down payment or closing costs, you still have a few options. If you are a first-time homebuyer, you can take money out of your retirement account without penalty, though you will have to pay income taxes on the amount used. You can also ask your parents. You can receive up to $12,000 in cash from each of your parents per year without them having to pay a gift tax on their gift to you.
Consider teaming up with an investor and/or a sibling. Someone may offer to pay the closings costs and down payment amount in exchange for an equal share of the house when it is sold at a later date. Consider other family members or siblings, for example.
Some companies will also help their employees with a down payment or with a special low-interest loan.
You may consider owner financing options as well. These are properties that the current owner is willing to finance instead of a traditional bank.
Additionally, someone in a really bad situation may be interested in you taking over the house payments in exchange for being able to get out of the payment each month. This is often done with little to no down payment and is referred to as "sub to" financing. This can be an awesome opportunity in the right situation.