How Credit Scoring Affects Your Credit

Because most lending is Internet based, a credit standard is needed to put everyone on the same page. As a result, credit scoring was developed and has become a universal, though sometimes controversial and misunderstood, standard.
FICO scoring, the industry standard, is named after Fair, Isaac and Co. the California-based firm that developed the software. It creates a computer-generated numerical grade that predicts a lender’s risk in loaning you money. Your FICO score can change from day to day depending on what information is available from various credit sources.
When a mortgage lender orders a credit report, the credit bureaus evaluate and assign a numerical score to five different parts of your credit history. Two of the five factors that relate to your payment history and how much current debt you have make up roughly 65 percent of the score. The length of your credit history, recent credit inquires, and type of credit you use make up the remaining 35 percent.
FICO scores range from 300 to about 850, and the better your track record paying loans back promptly the higher your score. Typically, scores of 650 plus get the best rates and terms. Homebuyers with scores in the 620 to 650 range still won’t have a problem finding a mortgage, but the interest rates may start to creep up. Scores under 620 are subprime territory, and interest rates can ratchet up 2 percent or more. Down payments required also climb, sometimes to as high as 30 percent.
When Ron and Wendy applied for a $175,000 mortgage, they didn’t think a couple of 30-day late payments on their two maxed-out Visa cards would cause a problem. But, when their lender called asking about a two-year-old medical collection account they had forgotten about, the situation started to look grim. Ron and Wendy told the lender they thought the insurance company was supposed to pay the bill. But they never took time to follow up and ignored several statements from the clinic. After about four months, the clinic sent the account to a collection agency, which reported to the credit bureau and Ron and Wendy’s credit score took a big hit. Each discount point equals 1 percent of the loan amount, and lenders often charge points to increase their yield (profit) on a below market interest rate.
With a credit score around 600, the lender felt she could still put a loan together
but Ron and Wendy would have to pay off the collection account first. They would also need at least 10 percent down, pay an interest rate one percent higher than the current market rate, plus two discount points.
In real dollars and cents terms a low credit score will cost Ron and Wendy: Two discount points, or $3,150 $104 a month in higher payments or $3,744 over three years. Hopefully, they can get their credit cleared up and refinance to a lower interest rate by then. The bottom line is that your credit score determines how much your mortgage will cost you in interest and closing costs. In Ron and Wendy’s case, not taking their credit seriously cost them $6,894 in penalties.