Elements of Credit

This post is from the Blown Mortgage Hall of Fame.  It originally appeared back in July 2007 on my series on credit.  Now more than ever your credit score is vital to securing financing.  I’m on vacation from Saturday until Tuesday the 15th so enjoy some of the classics while I’m gone. 

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In part 1 of this series on credit we talked about how important credit has become in surviving the current home depreciation environment and avoiding the ARM Reset Foreclosure Trap. Now that you know (hopefully) how important credit is to protecting yourself and family from foreclosure it?s time to look at the elements of credit to understand the factors that affect your score. You?ll use this understanding to your advantage in parts three and four as you work to improve your credit score both organically and through 3rd parties.

Credit Series Overview

  1. Why credit is so important
  2. Understanding elements of credit
  3. Improving your score organically
  4. Improving your score using 3rd party help
  5. Managing your score

Elements of Credit

Payment History – 35% of score

You might expect payment history to account for more; but in fact it only contributes to 35% of your credit score. It is however the most significant contributor out all the elements that are used in your score calculation. Late payments, charge-offs and judgments are all factors that have a negative impact. Missing high-balance payments have a larger impact than missing low-balance payments. Further, if you miss a mortgage payment you hurt your credit in two very critical ways:

  1. You incur a late payment on your highest-balance credit account causing the greatest harm to your score.
  2. You drop a credit grade on loan underwriting matrices limiting your loan options and increasing your interest rates.

Finally, most weight is given to your payment performance over the last two years. Older delinquencies are still a factor but are weighted less. If you maintain a clean payment history on your credit accounts for at least 24 months you stand a much better chance at getting lower interest rate, higher LTV loans. Which is exactly what you need access to when trying to avoid the ARM Reset Foreclosure Trap.

Current Credit Balances – 30% of Score

Credit balances are used to calculate the ratio of your credit used compared to the total amount of credit available to you for revolving credit accounts. To calculate this number simply take the total amount of money spent on an existing credit card and divide it by the card limit, then multiply that number by 100. This is your credit utilization percentage for that particular card. For example:

Credit Limit on VISA: $15,000
Current Balance: $10,000

$10,000 / $15,000 = 0.67 x 100 = 67% utilization rate

In the above example you have used 67% of the credit available to you, leaving you little remaining credit. This will negatively impact your credit score. While the ideal utilization percentage is somewhat debatable depending on who you talk to; most experts agree that utilization percentages below 50% (and definitely below 30%) favorably impact your score. In fact simply reducing your outstanding credit on any particular account from 51% to 49% has shown to provide significant score improvement.

Credit History – 15% of score

Credit history refers to the length of time that each credit account is open.  An account in good standing that has been open for 5 years carry much more weight on your score than an account in good standing open for 4 months.  The track record of your payment history is weighted to present a truer picture of your repayment habits.

Type of Credit – 10% of score

Credit bureaus frown on large amounts of debt from any one segment of financing.  Too much credit card debt will impact your score; too many auto loans can have the same effect.  The credit score is meant to paint a picture of responsible credit use.  If you carry 10 credit cards with high balances your score will be impacted; even if you make all of your payments on time.  That is because the excess debt burden makes you a higher risk for potential delinquent payments.

Inquiries – 10% of score

The dreaded credit inquiry.  Yes, they really do impact your score.  The total number of inquiries is evaluated over a 6 month period.  The first 10 inquiries can impact your score – anywhere from 2 to 25 points per inquiry!  This is a massive range.  It is no wonder why your gut says that credit inquiries are a bad thing.  Credit inquiries are factored in to your score because credit bureaus want to penalize people who are desperate for credit.  If you are applying for, and being denied, credit all over town that process is going to take its toll on your credit score.

There are two common misconceptions about credit inquiries that you should be aware of:

  1. All inquiries on my credit report are bad.  FALSE. If you make an inquiry in to your own credit history it is not seen as a negative.  In fact, you should personally check your credit every 6 months; and at least once a year to ensure its accuracy.
  2. Too many inquiries on my credit report are bad.  FALSE.  Too many inquiries over a long period of time are bad.  Credit repositories allow a 14-day shopping window for consumers shopping for products that require a credit check.  In this 14-day window you can have multiple inquiries in to your credit history with out a negative impact on your score.  With out this type of grace period no one would be able to shop competitors for financed items such as home loans, car loans, and financed home furnishings, appliances and electronics.  The damage is done when you repeatedly seek credit on an ongoing basis.

It is important to remember that the credit bureaus use an algorithm to determine your credit score; and they all have slightly different formulas which is why your score differs from each of the three major bureaus.  In the next segment I?ll talk about strategies to improve your credit score organically with out the help of outside parties.  You?ll be able to use your knowledge of the scoring model covered today to effectively manage your credit use to improve your score.

Remember, we?re trying to achieve the best credit score possible before we are forced to refinance.  A high credit score gives us our best chance at leveraging high loan-to-value mortgage products to get us out of adjusting ARM loans – avoiding the ARM Reset Foreclosure Trap.

If you?d like a free white paper on the elements of credit and how they impact your borrowing power please email me at [email protected].