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2 The Ultimate Guide to Understanding Your Credit Score (or: How your Credit Score is Calculated and How It Impacts Your Mortgage Interest Rate) Table of Contents Introduction... 3 Credit Score and Your Mortgage... 4 How does it affect your mortgage?... 4 So how do you do that?... 5 Establishing a Credit Score... 6 Calculating and Improving Your Credit Scores... 7 Payment History and Its Effects on Your Credit Scores... 9 Debt Level and Your Credit Scores Length of Credit History and Your Credit Scores Credit Inquiries and Your Credit Scores Mix of Credit and Your Credit Scores Credit Scores Are Not So Complicated Conclusion Free Consultation page 2

3 Introduction Going to a bank to apply for a mortgage is probably one of the most nerve- racking experiences you could ever have in your life. There you will sit, in front of the stone cold loan officer who will be interviewing you, asking about your credit history and current financial status, and anything else they feel is relevant to your ability to qualify. No matter how much you try to impress that poker-faced officer with your polite behavior and eloquent speeches, the icy cold stare you usually get makes it feel like your cards are just not good enough. However, your experience does not end there. After leaving the loan officer, you have to spend days and even weeks thinking and worrying about whether your loan is approved or rejected. Having it rejected makes for a terrible ending to the whole experience. Tsk, tsk To avoid this excruciating and painful experience, one of the things you ll need is a good credit score (the other thing is a friendly mortgage broker!) If you have a relatively good credit score, then the chance of getting your mortgage is much higher. On top of that, your mortgage can come with a lower interest rate, too. There are many ways to bump up your credit score and get that mortgage, but before going to that, here is some brief info about credit scores and its effects on your mortgage. page 3

4 Credit Score and Your Mortgage Whenever you take loans or borrow money from a lender, you automagcally gain scores that serve as a basis for future loans. These scores are what they call your Credit Score. The next Gme you take another loan, banks and lending companies can pull out these score sheets and scrugnize them to see how good of a borrower you are (translagon: how well you paid back the money borrowed). Here are some things that lenders will learn from your credit score: Do you pay your debts on time? How much did you borrow in the past and how well are you doing at paying them? How many credit accounts are you presently holding? Can you pay off the loan along with its interest? These are just some of the things that lenders will look at whenever they study your score sheet, and the data on the sheet reflects your ability and credibility in making monthly payments. The data will provide lenders with the necessary information about your lending history. Think of your credit score report as a diary where they keep track of your financial status, from previous years until the present. How does it affect your mortgage? Getting a new house can be very stressful if you do not have a credit score. Take a look at the two following scenarios: Scenario 1: Mr. Smith just got married and planned to buy a new house for the family he and his wife are about to start. However, he doesn t have enough cash to pay for it in full, so he sets out to get a $250, year fixed interest mortgage. When he applied to the lender for the mortgage, they told him that he did not have enough credentials for a mortgage. One thing he lacked is a credit score, which would have served as a basis for lenders to know if he could actually afford to pay back the loan. Because the lenders were unsure about his creditworthiness, they rejected his application. Scenario 2: Mr. Wilson already has a new car, and now what he wants is a new house with a nice page 4

5 garage to park it in. So, he decides to apply for a $250, year fixed interest mortgage on a new house. However, he does not have a credit score to prove his ability to handle and manage a loan. Nevertheless, the bank eventually gives him the loan by taking his new car as collateral, and he gets the house. However, since he does not have a credit score, he has to pay a higher interest rate. He needs to pay $1,527 in monthly amortization, resulting in $299,821 in interest over the 30-year period. Had he had a well-established credit score, the interest would have been $201,681 a difference of almost $100,000. These two scenarios are typical for people who do not have a credit score, and they show how important a credit score is when applying for a mortgage. In the first scenario, you can see how your credit scores can affect the approval of your loans and mortgage, while in the second scenario you can see how much money you can actually save while paying for your mortgage. Why would you want to pay the bank an extra $100,000 if you don t have to? These are the reasons why you need a credit score and you need to raise it to the maximum level possible. The higher your credit score is, the higher the chance of your mortgage being approved and at a lower interest rate. So how do you do that? You need to study and acquaint yourself with the different things that affect your credit scores, most of which you will find in the following pages (you re welcome!). There are things that can affect your credit score in a negative way, pulling them down to dangerously low levels and increasing your chances of being rejected. However, there are also things you can do to improve your credit score, increasing the chances of your mortgage being approved. page 5

6 Establishing a Credit Score First things first. Before you can get a credit score, you have to get credit. This may be in the form of credit cards or other loans. It is best to start early, like while you re sgll studying. Student loans are a great kick- off for establishing your credit score. For college graduates and the employed, you can start with a credit card or an auto loan. You can then build up your credit score by engaging in other types of loans. Accordingly, getting two credit cards and a loan will give your credit score a boost. If you have a current or existing savings account, you can always ask your bank if they can provide you with a credit card for those who have limited credit history like you. In other cases, they may be able to provide you with a secured credit card (one that requires a deposit), which you can later turn into a nonsecured credit card. One confusing thing about credit scores is that the more credit you have, the more credible you are of course that s if you re able to pay them properly and on time. This can be quite dangerous as it can lead others to borrow more, and later on have a difficult time paying them off. Therefore, it is better to stick to what you can handle for the moment, and be wary about getting too many accounts at once. Even though you have a standing credit, you might be surprised that you haven t built-up any credit score. But before you get to thinking you just wasted your time, here are some explanations to help you understand your little or lack of credit score. Time is the issue here. If your credit history is quite short, say less than half a year, then you re most likely to gain only a limited credit score or none at all. Therefore, what you want to do is to increase the length of your credit time, at least something longer than six months to be safe. Now that you ve established a credit score, what you need to do is bring them up to an impressive number. page 6

7 Calculating and Improving Your Credit Scores Before geyng to the part about improving your credit score, it s important that you know how your score is calculated. This allows you to bezer understand how you can improve your credit score, and idengfy the necessary steps and measures that you need to take. There are a variety of ways that your scores are calculated. Several companies are involved in the calculation of the score, for example FICO, Equifax Canada, TransUnion Canada, as well as some other banks. The most commonly used calculation method or model by many lending companies and banks is the FICO System. The FICO score is a system developed by Fair, Isaac Corporation as a means to help banks and moneylenders with the decision-making processes regarding the approval of mortgages and loans. They are the largest and most reputable score provider to date, and their scores are highly trusted by moneylenders and used in North American areas, namely the United States and Canada. As such, your FICO score may be one of the biggest factors in getting your loan approved. Aside from this, they also help banks and lenders determine the right interest rate for you. Your FICO score is expressed as a three-digit number that ranges from points. Just like in any grading system, the higher your score, the better. To better understand how the FICO scoring system can affect your mortgage interest rate, here is a rough estimate of the interest rates that corresponds to each FICO range or tier: NOTE: The FICO scoring system is a patented and copyrighted system, so the exact details of the scoring process in known only to those who purchased it or work for FICO. The numbers shown here are only estimates to give you an idea of how your score can affect the interest rates of your mortgage. Every point in the credit score is important, because they can help you shed a few thousand dollars difference in your interest payments. That s right. THOUSANDS. For example, lending companies have specific rules that when your credit score is 700, then you can get an interest lower than the usual. If page 7

8 your score is 600, then chances are you won t be getting that low interest rate. Lending companies are strict about this kind of rule, and being near the cut-off range is not the same as being over it. Your FICO score is calculated based on different criteria. There are five criteria that your credit score is judged against: payment history, debt level, length of credit history, credit inquiries, and mix of credit. page 8

9 Payment History and Its Effects on Your Credit Scores Payment history holds the most weight among the five criteria it accounts for a whopping 35% of your score! Your payment history reflects how good you are at paying your bills and credit. As such, your score in this criteria translates how trustworthy and reliable you are, some of the things the lender will be looking for in a borrower. Your payment history is reflected in your credit report, so whenever you miss a payment, your score is sure to go down. In order to avoid losing points, there are two simple things you need to do: pay your bills and pay them on time. However, not all delinquent payments have the same effect on your credit score. For example, if you miss paying your bills once, then the effect won t be as bad as you might imagine. When you miss it twice, the problem starts brewing. Miss it a third time and your credit score will surely suffer a dramatic fall. Being late in paying your bills and balances is also treated differently. Just imagine this scenario: being late once in paying your monthly dues can lower your score by 30 points. That is, of course, if you have only one credit account. If you miss two payments in one month, that number can double, and it can take years to regain the lost points. A late payment of thirty days is still acceptable, but beyond sixty days will surely have a negative effect on your credit score. Being late for ninety days or more leaves your credit score a total mess. page 9

10 Two things that can terribly damage your credit score and reflect badly on your credit score report are judgments and collections, which will be explained through the following scenarios. Mr. Jones decides to leave his present apartment to move to a new one without having completed his lease contract with his landlord. This simply translates to the fact that he did not fulfill his end of the contract, which in most places is considered as a grave offense. This may or may not affect his credit score depending on what his landlord decides to do. If his landlord decides to let it go, he may not report this offense to the credit company, thus keeping Mr. Jones records clean. However, if his landlord decides to press charges against him, then this will automatically be included in his credit score report as a judgment, lowering his credit score. This situation also applies to your cell phone and telephone bills, as well as bank overdrafts (overdrafts happen when you spend more than what your checking account allows). If you missed a payment, they may not report you to the credit bureau. However, if they get tired of waiting for you to settle your standing balances, then they may sue you, and soon a judgment may follow. In most cases, they will get a third person entity to do the collection for them. This reflects on your credit score report as collection. Not only is collection embarrassing, but it can also totally wreck your credit score. It s quite easy to lose points in your credit score, and getting them back can be the exact opposite. Accordingly, some people have had to wait years before their credit score regained the lost points. Therefore, building a wellestablished payment history should be one of your primary objectives if you want to apply for a mortgage. page 10

11 Debt Level and Your Credit Scores Your debt level comprises 30% of your credit score. This is the second highest criterion, and scoring low in this area will surely make banks and money- lending companies think twice about giving you that mortgage. Debt level is an important consideration as it can tell lenders how much you can actually pay. Here is a scenario showing how debt level can affect your overall credit score and your loans: Mr. Johnson has standing balances in his credit cards. Aside from that, he needs to pay his other bills and auto loan. In order to pay for these things, he needed a loan. The bank, however, saw his credit score report and the unpaid balances therein. They automatically rejected his application, since experience shows that people only go deeper into debt whenever a new one is added. In most cases, people do have a hard time getting back on their feet after being sunk neck-deep in debt. It is only business-wise that lending companies stop loaning money to those who are already treading in troubled waters. Whenever FICO or one of the credit bureaus calculates your credit score, they take into consideration your current debt level. Here are some things they look at: How much do you presently owe to other lenders, specifically on revolving accounts (i.e. credit cards) and installment accounts (i.e. mortgages) How much debt there is in every account you own One more thing that credit companies look at is your credit utilization ratio. Credit utilization refers to how much of the amount credited to you are you actually using. For example, if your credit limit is $100 dollars and you use only $10, then that means your credit utilization is only 10%. page 11

12 That being said the best way to increase your credit scores is by lowering your credit utilization ratio and your standing credit balances. If not, you can try to increase the credit limit in your cards either way your credit utilization would stay low. In addition, there is no point in paying your balances in full at the end of the month. Assessors send their reports to the credit bureau any day, not necessarily at the end of the month. if you are serious about keeping your records clean, then it s best for you to know when your banks send your credit report to the credit bureau, and make sure you pay your balances before that time. A debt settlement is another thing. This is when you and your creditor agrees to a payment lesser than the agreed amount. Here is an example: Mr. Walker is in debt of $100,000 to a credit company. He really wants to settle the debt in order for him to clear his name, so he seeks the help of a debt settlement company. The debt settlement company collects monthly fees from Mr. Walker while negotiating with the credit company. All this time, Mr. Smith keeps receiving phone calls about his debt. After some time, Mr. Walker (with the help of the debt settlement company) and the credit company agree to a payment of $60,000. After clearing his debt, Mr. Walker feels good about making a new loan, thinking that his credit score record is clean and good as new. So is debt settlement a good thing? Not entirely. If you think about how much discount you got, then yes, it s a good thing. But if your concern is about increasing your credit score, then it is one of the worst mistakes you can make. Here s why... When you decide to use the services of a debt settlement company, your money goes to them instead of your creditor. Thus, you debt remains unpaid in the reports they submit. Remember, delinquencies can lower your credit scores. The longer the debt settlement takes, the longer your unpaid status remains on the report. When you and the credit company decide to settle on an amount lesser than what you owe, then they will write off your debt in the report as paid. Sounds page 12

13 good? Not really. What you want to appear in your credit score report is paid as agreed not simply paid. The difference is pretty clear. So when you think about decreasing your debt level through debt settlements, think again. Debt settlements are not for people who are looking to build a reputable credit score. To money lenders, debt settlement via credit counseling and consumer proposal is seen to be just as severe as bankruptcy. page 13

14 Length of Credit History and Your Credit Scores Another criterion in calculagng your credit score is your length of credit history, which refers to how long you have had credit. This criterion makes up 15% of your total credit score. Having a long credit history may not sound very reassuring, but it actually is. You see, the longer your credit history is, the better your credit score will be. Your credit history allows the lender to assess your ability to pay off your loans. This somehow gives lenders assurance about how good you ll be as a borrower. Having a long yet well-established credit history can take years to build. Many successful borrowers who score high in the credit score calculations have as much as 20 or 30 years of credit history. It s difficult to maintain a perfect credit history. Nevertheless, all is not lost. Having a credit history with few inconsistencies is better than not having a credit history at all. Do you remember the case of Mr. Smith and Mr. Wilson in the earlier pages? That is what happens when you do not have a credit history. Regarding length of credit history, there are several myths about it. Here is one example: Mr. Richards has three credit cards, one he acquired in college and is now 15 years old. Two more he got 10 and 5 years later. Seeing no more need for his first credit card, he thought about closing it. However, he is reluctant to do so, believing that his credit history might be cut short of 15 years. This is not entirely true, because even when you close an account, it will remain in your credit reports for a few more years. If your credit card balances are paid properly, they will remain in your credit score reports for ten years, assuring that you can use that good payment standing even if the account is closed. If your credit card balance payments are late, then that will remain in your credit score report for seven more years. So whether you choose to close a reputable account or a bad one, they will still stay in your reports. Keeping a long and well-establish credit history will show your creditors how much experience you have had in handling credits. This is a plus point if you apply for a mortgage and hope to get a lower interest rate. page 14

15 Credit Inquiries and Your Credit Scores A credit inquiry is another criterion in calculagng your credit score and makes up 10% of the total. Whenever you apply for a loan or a mortgage, the credit company will do a background check on you and your current financial status. This is what they call a credit inquiry. Aside from credit companies, other businesses can also check your credit reports like the banks. When you apply for a credit card, the bank will surely do an inquiry about your credit report. There are two types of inquiries that can be made: a soft inquiry and a hard inquiry. The soft inquiry is where you check your own credit report. This does not lower your points in the credit score sheet. Hard inquiries on the other hand can hurt your credit score. Hard inquiry happens when you apply for a new loan or a new credit for the reasons explained in the above paragraphs. Although the points deducted are low, they can have an impact in your credit score. This is because the scorers know by experience that the majority of people who take new credit have a hard time paying their bills and become delinquent which is very true in many cases. Also, too many credit inquiries can mean you badly need money, making you a risky borrower. This can lower your credit score by a few points, and decrease your chance of getting an approval for your mortgage. However, this does not mean that you cannot inquire about other loans when you already have one. Provided that the span of time between the inquiries made are short and near each other (say 30 days or so), the calculating company can treat it as a single inquiry, and you ll find that your scores will start to rise again. Credit inquiries that you made in the last three years are included in your report. However, only the credit inquiries that you made in the previous year will have bearing in the calculation of your total credit score. In addition, if you have a successful credit history, then the impact of credit inquiries will not be as devastating. page 15

16 Mix of Credit and Your Credit Scores Credit mix or having different types of credit in your account is another criterion in the calculagon of your credit score, and they make up 10% of your overall credit score. Although you can score well with only one credit type, most credit companies and banks would feel reassured if they know that you are able to handle different types of credit, as it shows how financially equipped you are, making you a less risky borrower. A good credit mix can include installment accounts like loans and mortgages, and revolving accounts like credit cards. This way, lenders know that they can trust you to handle the money well. It does not really tell how much of a good payer you are, but it can help in determining how you will treat the loan. Since having a variety of credit types is good for your credit score, does this mean that you should go ahead and get as many loans and as much credit as you can? Credit companies do not consider all types of credit, but only those that can be considered major and reputable. For example, a major credit card like Visa or Mastercard can help in improving your credit score report; while cards issued by stores and shops to earn reward points as a good shopper are invalid. When applying for credit cards, a prepaid credit card (where you have to make a deposit) does not boost your credit score simply because they don t consider it as a credit card. A secured credit card on the other hand is more likely to show up in your credit report, and if managed well, can help boost up your present score. The real danger here is when lenders check or make hard inquiries on your credit report. As mentioned, hard inquiries can do a certain amount of damage to your credit score. Thus, if you do not need the loan or credit, then don t take one. Other things are more important than a variety of credit types. No. page 16

17 Credit Scores Are Not So Complicated Aside from knowing the different factors behind your credit scores and its effect on your mortgages, here are some other things that you might need to know before you jump on the phone with your favorite mortgage broker and apply for a mortgage. So first, where do you get your credit score report? You can always get your credit reports from FICO or one of the major credit bureaus in Canada namely TransUnion Canada and Equifax Canada. As of this writing, TransUnion and Equifax can provide you with a copy of your report a couple of times a year free of charge. Another thing that makes credit scores sound complicated is the different credit scores that you get from each of the different major credit bureaus. The differences you see when you compare your credit scores from these major credit bureaus are basically because of the differences in the models they use to calculate your credit score. For example, as of this writing, Equifax Canada is the only one of the three to use the FICO scoring system, while TransUnion has developed their own scoring model. The models takes into account the different information about you and your finances, calculates them according to their models and then presents you with the result of your credit score. Speaking of calculations, there are some things that the credit companies do not take into account when calculating your credit score. For one, an apartment rental does not fall into any of the criteria that your credit score is judged against, not even in the credit mix criteria. Accordingly, apartment rentals have no or little use in the calculation, and can only provide (if ever) a very small amount of relevant information. Old addresses in your account do not have any bearing in your credit score as well. They are not in any way part of the criteria nor its sub-criteria. page 17

18 Another complicated thing about credit scores is that they almost keep on changing, making it difficult to keep track of your credit scores. Since you need your credit scores when you apply for a mortgage, you must have it ready six months prior to the application. Inconsistent credit scores can cause a big problem, and spell the difference between getting that loan or not. However complicated it may sound, the changes that happen in your credit scores are normal. They may change daily, weekly or even monthly, and this is because your credit report is being updated. The credit bureau you belong to must update your credit scores, it s a part of their responsibilities and obligations. Concerning your scores, the higher your score is, the farther it will drop. Say for example: Mr. Denver has a credit score of 700 while Mr. Edwards has a credit score of 800. Both people missed paying for their credit card balance once. Do they lose the same points? No. Mr. Denver tends to lose about 10 points or so, while Mr. Edwards tends to lose more points, about 20 points or even higher. In whatever situation, whether it is a late payment on your loans, judgment, or collections, the person with a higher credit score will definitely lose more points than the one who has a lesser credit score. If you spot any inconsistencies in your credit score report, it is best that you contact your credit bureau immediately to clear them up. These inconsistencies usually happen due to similarities in background information, like similar family names. Neglecting to fix these inconsistencies will surely hurt your credit score. page 18

19 Conclusion Now you can see how important your credit score is when you apply for a mortgage. Getting a mortgage is one of the most difficult and time-consuming tasks you might ever have to do. However, no one can disregard the benefits that a mortgage can give, especially to those who are just starting a home. Thus, it is important that you do everything in your power to make sure that everything is in order before applying for a mortgage. As mentioned earlier, your credit score helps to determine your chances of whether or not you will get the loan. As such, it is only one of the factors, and not the deciding factor. Other aspects like having a huge amount of cash in the bank or highly assessed collateral can help to get you that mortgage even with a low credit score. That does not mean that you can neglect your credit score. Yes, you can probably get a mortgage with just a collateral, but what about the interest rate? A good credit score can show your creditor that you are an able payer, and this can increase their confidence on you as a borrower. So keep your score up and you will surely enjoy lower interest rates and an increased likelihood of your loan being approved. With a high credit score, you will not only get that loan, but you re opened to various opportunities and sweet deals on mortgages, making sure that everything you spent in making your credit score report perfect (or almost) is worth it. page 19

20 Free Consultation If you have quesgons about credit scores, mortgages or the applicagon process please contact me. I d love to help you out! MenGon this report for a free consultagon or schedule one here. Phone: raeann@mortgageengineer.ca page 20