One of the most common conversations I have as a Mortgage Broker is around credit and I constantly hear the phrase "I wish they taught us this in school". The funny thing is that they do actually try to teach us this in school, but we are 16 year old's concerned more about who we were going to prom with than our future self needing to buy a house so most of us paid zero attention! Then we become adults and really wish that our 19 year old past self knew how a credit card worked and many have to work to fix the mistakes of the past. The good news is that credit can be fixed, and in some cases, relatively quickly. I hear and read so many conflicting and incorrect details on how credit scores are calculated and how credit management affects your mortgage approval so let's break down the main pillars of your credit score and how to maintain good credit.
Credit Utilization - 30% of your score
This is the biggest factor that I see routinely affecting borrowers credit scores. How we use credit makes up 30% of your score and is entirely based on your credit habits and usage of credit. That means, this is also one of the biggest areas you can improve your score by managing credit correctly.
The bureau wants to see that you have credit available to you, but that you don't rely on it on a month to month basis to get by. This means, having a healthy limit on your credit card does not hurt you, but maxing that limit out does.
We like to see that for revolving credit items like credit cards and lines of credit, that a client does not have more than 30-50% of the limit owing every month at the date it reports to the bureau. So if you are carrying a balance on your credit card, this will negatively impact your credit if you carry a higher amount relative to the limit. It doesn't matter the amount of debt, it matters the % of your credit you are using (within reason). For example, a credit limit of 2k on a credit card with a balance owing of $1800 is showing an almost maxed out credit card and will report negatively to the bureau hurting your score whereas a credit limit of 10k with a balance of 3k owing will actually look better to the bureau despite there being more debt. Now I'm not saying run out and increase your limits and charge up more debt - but you should think twice about decreasing limits on credit cards if you don't use them to capacity and if you are using your card to capacity and paying it off each month, you likely could stand to increase the limit.
I had a client a few years ago that had very healthy incomes and they used their card for every purchase to maximize points from the card. They then paid the card in full each month. They had a 10k limit and routinely charged around 8-9k a month to the card and the credit score was around 680. They increased the limit to 20k and continued to spend the same amount each month and paid it in full each month, within a few months the score improved over 100 points. The change from 90% utilization of their limit to 40% utilization on average made a dramatic change to how they were viewed.
Limits should be relative to your income level and make sense, having excessive credit available can be a bad thing and label you as a credit seeker, however, having a reasonable amount of available credit as emergency money is not a bad thing. Credit cards report to the bureau on the statement date, this means if you have a maxed out credit card and interest is added to the card on the statement date and then reported to the bureau, you might be over the limit of the card on the same day simply by interest being applied to the account. Over limit on credit cards is a massive score dropping item. I have seen 100 point drops for clients going over the limit on the card once. If you are carrying a balance on your card, it is worth it to ensure you have a healthy gap between your debt and the limit to ensure that interest charges do not put you over the limit on a monthly basis.
If you are carrying credit card debt, it might make much more sense to seek a consolidation loan from the bank or transition that debt to a line of credit instead of credit cards. If you have a good chunk of equity in your home, you can also speak to your broker about refinancing and consolidating the debt into your mortgage or obtaining a secured line of credit on the house to carry that debt instead. These items do not report as negatively to the bureau as maxed out credit cards despite carrying the same amount of debt overall.
Payment History - 35% of your score
Making your payments on time, every time should be top priority. This is the largest factor in determining your credit score and should probably go without saying = pay your bills on or before their due dates. Though, some items look worse than others, a late payment on a cell phone will not weigh as heavily as a late payment on a car loan for example. That said, all late payments will negatively affect your score and you will be required to explain the reason for any late payments on a mortgage application.
Excessive late payments may lead to a collection or judgement on the bureau and these items will have a dramatic negative impact on the score as well, and despite common myth, they don't simply 'fall off the bureau' after 5 years. Collections will stay on the bureau for 5 years that is true, but collections can be sold on to the next collection agency and re-registered on the bureau again. It can also take years sometimes for a collection to be registered on the bureau meaning that one collection could still be haunting you for decades to come. Pay your debts, and pay them on time to avoid the damage to your score.
Length of Credit History - 15% of your score
The bureau wants to see that you are reliable, not jumping around from one card provider to the other or constantly opening and closing accounts. It is far better to choose a card and stay with it than to be routinely seeking new credit by applying for new cards or new loans and closing old accounts. A person who is constantly applying for new credit can be deemed to have credit seeking behavior which will negatively impact a lenders decision to lend to you. Long standing history with one credit card shows that you have effectively managed that item for years without concern and shows financial maturity and reliability for credit use which makes it easier to determine a score and credit worthiness.
Inquiries - 10% of your score
No doubt the most misjudged category of a credit score is the credit checks category. I routinely hear from clients comments like "I don't want you to pull my credit, it will hurt my score" when these are the same clients who have 14 late payments on their cell phone and are over the limit on their credit cards.
To clear this up, yes, excessive credit pulls will hurt your score. What is excessive? I once saw a bureau with over 200 credit pulls in a 5 year period of time. That is certainly beyond excessive. However, a reasonable amount of credit pulls would never look like that. But to be very clear, having your credit pulled a few times too many will not impact your score nearly as much as the balance owing on your credit card or missing a loan payment, so while monitoring and not applying for credit too often is a piece of the puzzle, it is not the main factor that everyone makes it out to be. If you have good credit, credit pulls won't hurt your score when it comes to applying for a mortgage. If you have poor credit, every little bit can damage the score further. Credit application types are lumped in together within a 45 day window, so if you are shopping around for car financing for example your application is sent out to a handful of lenders at the same time and you may see your credit get pulled 10 times from 10 different lenders however these are all lumped into 1 pull from the bureau's perspective within a 45 day window. In short, having your mortgage broker pull your credit when you apply for a mortgage is not going to damage your credit score. Having 3 banks and 4 brokers pull your credit over a 3 month window of time as you shop around for your mortgage renewal, yes, that will hurt your score. However, as this category only affects 10% of how the score is calculated and most people do not get their credit pulled excessively this rarely has an impact for most borrowers when looking at a mortgage application.
Type of Credit - 10% of your score
The last category is the diversity of credit types on your bureau. The bureau likes to see a robust well rounded credit user. This means someone with a line of credit, credit card, mortgage and car loan will likely look more robust and have a better score than someone with just 2 credit cards. Especially when considering the length of time for the credit lines and the usage of them. This category can be difficult though, and I tend to let my clients not worry too much about this item as it would not be beneficial for most people to go out and get a loan just to have diversity on their bureau. However, if you are faced with getting a personal line of credit or applying for a third credit card - the line of credit would be the wiser choice to satisfy this category of the score. And hey, a mortgage could help with this one sure, but one thing I like to remind clients is that going into debt so that you can improve your score and go into more debt later is not really the right way to think about it. There are plenty of other ways to improve your score without applying for new and different types of debt.
What is a good score?
That depends on what you want to do with it. From a mortgage lending perspective, the best interest rates and easiest approvals come for clients with scores over 680, the higher the score the better. Clients with scores under 680 might face increased scrutiny, higher interest rates, more down payment required, co-signers, less lender choices etc. depending on the reasons for the score being lower. The minimum score to be on a traditional mortgage with a regular bank/credit union etc. is typically 600, however, just because your score is 630 doesn't mean you will be approved. The score is only one piece of the overall application and lenders look at the history on the bureau to determine if you are credit worthy not just the score itself. For example, if you just finished a bankruptcy or consumer proposal and have rebuilt your credit to a 650 score it does not mean you will automatically approved if you have not shown the proper time since the discharge or proper rebuilding. For more details on how a bankruptcy or consumer proposal will affect you - check out this blog post I wrote on this topic specifically.
It is also worth noting that there are different types of scores and levels of detail available within a score. Credit tracking apps like Credit Karma might show you a consumer score or a Trans Union score instead of a Equifax score for example. A consumer score will almost always show a bit higher than a full FICO score from Equifax which is what most mortgage lenders use. So if you are applying for a cell phone account, they will see less detail and a higher score than if you are applying for a mortgage. Even the score you will pull yourself from Equifax will be a bit different than a score the mortgage broker or bank pulls for the mortgage application and this is simply due to the level of detail and how the score is calculated for different types of transactions or lender categories.
As always, if you have any questions on this or any other topic related to mortgage financing, give me call 780-720-4034 or email me jill@jillmoelleringmortgages.com