Your credit score is an important factor when applying for a home loan. When you apply for credit – whether for a mortgage, auto loan, or credit card – lenders will order a credit report to summarize credit risk. Your credit score influences what is offered to you, and will have an impact on the loan terms and interest rate.
The most widely used credit scores are FICO scores, created by the Fair Isaac Corporation. 90% of top lenders use FICO Scores to make credit-related decisions. They are calculated based on information that gets reported to the credit reporting agencies. By comparing this information to the patterns in hundreds of thousands of other credit reports, FICO Scores estimate your level of future credit risk. FICO Scores range from 300-850. The higher the score, the lower the risk.
There are three credit bureaus: Equifax, TransUnion, and Experian. Each credit bureau has a FICO Score for you, which may differ than the other bureaus, based on the information that particular bureau keeps on file about you. Your FICO Scores evolve frequently and will change over time due to many factors.
So how is your credit score calculated?
35% Payment History
30% Amounts Owed
15% Length of Credit History
10% New Credit
10% Credit Mix
Payment History (35%)
The first thing a lender will look at is how you pay your bills. This shows whether you’ve paid past credit accounts on time, which will help businesses decide if they want to extend credit and offer you a loan, credit card, or even a job. Be sure to pay all your bills on time to establish a good and consistent pattern. Even bills that don’t get reported to the credit bureaus (medical bills, phone bills, etc.) could end up on your credit report if you fall behind, and get sent to a collection agency.
Amounts Owed (30%)
Lenders will look at how much credit you use compared to how much you have available. Keeping your balances low will help to improve your credit. Being “maxed out” will cause your scores to go down. Balances should be around 30% of your credit limit. For example, if your available credit is $1000, you will want to keep your balance around $300 or less. If you are using a lot of your available credit, this could indicate you are overextended and represents a higher risk of defaulting.
Length of Credit History (15%)
Typically, longer credit history will increase your FICO scores. Lenders will look at how long your credit accounts have been established. An account that’s been open for a long time, showing good payment history will help to boost your scores. New credit accounts will lower your average credit age, as there is no pattern or history to interpret. Do not close out old credit cards, especially those with good payment history. This reduces your overall available credit and will shorten your credit age, which could lower your score.
New Credit (10%)
Apply for credit only when necessary. Having your credit pulled often in a short amount of time represents a greater risk, especially if you don’t have a long credit history. Too many inquiries could be a red flag, as it could possibly mean you have opened new accounts which are not reflected yet on your credit report. A lender may require a letter of explanation if they deem your inquiries as excessive.
Credit Mix (10%)
Lenders favor consumers who can handle different types of credit. Having a mix of credit on your credit report can indicate less risk than those who have experience with only one type of credit. Revolving credit is your credit cards – where you are able to establish a pattern of using the available credit: paying it down, using it, paying it down, etc. This shows you are able to manage your credit well. An installment loan is when you are offered credit, and as you lower the balance by making payments, the loan naturally closes (student loans, auto loans, etc.). This does not mean you should go out and apply for credit cards or personal loans if you don’t have them!
Watch your credit report! You get one free report from each credit bureau every year. Check it out and be sure your information is correct. Do you recognize your accounts? Do you recognize the places you applied for credit? Fix anything that is not correct.
Focus on the fundamentals: always pay bills on time, keep credit balances low, and open new accounts only when necessary. Check your credit report throughout the year.