Several weeks ago, I started a series on What the banks are looking for to approve you for a mortgage.
Today we take a deeper look into credit scores, a large factor in the lenders’ determination of whether they can trust you to pay back the loan.
To be clear from the start, your credit file is more than just a score, and the score isn’t everything in determining credit worthiness. But it is a big thing, so that’s where we start.
Credit scores range from 300 to 900. Anything below 550 is a bad score, anything above 725 is a very good score. Generally, to get a 90% or 95% mortgage, you will need a credit score of at least 680. (I say “generally,” because the criteria are not absolute and may be swayed by other variables.)
So how is your score determined? The algorithms are complicated, but there are five factors that go into their calculation, with varying weights given to each. Today we look at the first two.
- Payment history (35%)
This is the largest factor in determining your score. Do you pay your bills on time, regularly? Each month, usually within the first ten days, your creditors—credit card issuers, bank loans, retail loans, mobile contracts, mortgages and lines of credit—report to the two bureaus, Equifax and TransUnion as to whether you paid up that month. If you did, the report will say something like “Paid as agreed and up to date.”
If you didn’t make a payment that month, though, that will be reported as missed. Your credit file will give you an R1 (or I1 or M1, depending on the type of credit line it is), meaning you have a 30-day delinquency. Miss another month, and your 60-day delinquency will be reported as R-2. And so it goes, up to R9, which is, of course, very bad.
Every late payment will affect your score negatively. Just one late payment may not kill you but the recency of any delinquency, the amount, any accumulation of delinquencies and the frequency of delinquencies will all add up to negatively affect your score. With over 200 points up for grabs (35% x 600 pts = 210) in payment history, that’s a lot to lose.
The credit bureaus will generally keep your payment history for the last three years. But even one delinquency within the most recent year may cause a lender to decline your mortgage application.
Bottom line: Even if you can pay only the minimum amount, never be late with your monthly payment requirements if you want to get a mortgage.
- Credit utilization (30%)
Credit utilization, the second largest factor, is complicated; it can affect your score both ways. Having debt (reminder: your debt is a bank’s credit, so we’re talking about the same thing), is not necessarily a bad thing. Insofar as it recognizes that others have judged you worthy of that credit file (debt), it reflects positively on you. But it hurts you if it demands too much of your income. So, it is the amount of credit available, the amount of total debt owed, and the proportion of debt compared to credit availability that are all factored into your score.
First, the positive. The higher the collective credit limit that you have been approved for, the more it looks good on you, and the more it will push your score up.
But, the negative is that using the credit that’s available will make you score go down, especially if your utilization of the available credit is high. Generally, every account for which you are using more than 50% of the available credit will make your score go down, the greater the level of utilization, the more the effect.
The less of the available credit you are utilizing, the less the negative drag will be on your score. When you get under 50% utilization, it will begin to increase your score (You have been judged to be worthy of a lot of credit but are using only a small amount of it, demonstrating your discipline.)
In calculating your score, the algorithm will take into account your credit utilization amount and the utilization ratio for each credit line individually, as well as for all of them, collectively.
So, if your sole objective is to raise your score, there are a number of things you can do to raise it quite quickly.
- Get the limit raised on your credit cards, but then don’t use the extra availability. This will simultaneously increase your total credit available and decrease your utilization rate. Of course, you don’t want to ask your bank to raise the limit if they’re unlikely to approve the raise, because the credit check they do on you will then lower your score, a subject we will address next time.
- If you have several debts, pay them all down to 50% or less, rather than paying off one while keeping the others high;
- Never cancel an old credit card that is paid off; just don’t use it anymore. If you cancel it, that will simultaneously lower your total credit availability and increase your utilization ratio, both of which lower your score. Even if you never use it again, it will continue to have a positive (though waning) effect on your score for up to six years.
Of course, if you cannot trust yourself to be disciplined with these steps, then you should not attempt them. But then you also need to face the reality that you will probably never qualify for a mortgage, and accept the likelihood that you will never become a homeowner.
Next time we’ll address the other three factors that influence your credit score.