Last week Realtor.com asked “Do you know what affects a homeowner’s credit rating?”  It’s a good question - and an important topic - so I thought I’d blog about it today.

The most commonly used credit scoring method is the FICO score.  There are 5 factors that are used to determine your FICO score, as you can see in the chart below.  The percentages reflect the relative importance of that factor; in other words, payment history is the most important factor, but is only slightly more important than amounts owed.

Source: MyFICO.com

The whole point of a credit score is to offer lenders a quick and easy way to estimate the risk associated with lending money to you.  If lending money to you is riskier, because you’re more likely than someone else to default, the lender will charge you a higher interest rate to compensate for that higher risk (or will simply not lend to you at all).  So all of the factors that are used to determine your credit score are factors because they’re statistically relevant ways to estimate the risk you represent to a potential lender.

Payment history

The payment history factor is fairly simple to understand: it takes into account how you’ve paid your bills.  After all, your history of debt repayment is an excellent indication of whether or not you’ll pay your debts on time in the future.  It includes delinquencies, foreclosures, bankruptcies ­ - as well as how many accounts were paid late, the amount(s) that were paid late, and how recent those delinquencies are.

Amounts owed

Almost as important as how you’ve paid your bills is the amount of debt you hold.  That’s because the more debt you hold, the higher risk there is that you will become overburdened with debt and unable to meet your obligations.

In fact, when I spoke with a local real estate attorney about the topic of strategic mortgage defaults, he told me that there can be a trade-off between payment history and amounts owed, at least for people who have other non-mortgage debt.  “If a person makes the decision to stop paying his mortgage, and instead puts that money to paying off other debts, then the credit hit that comes from the short sale or foreclosure will be partially offset by a credit boost from having less other debt.”  (Not that I’m advocating for strategic mortgage defaults.)

Length of credit history

The length of time that you’ve had credit and debt is a good indication of your credit risk because the longer your history of on-time debt repayment, the more certain a lender can be that you will continue to repay your debts on time.  If you’ve just begun to establish your credit history, on the other hand, the lender has less “past behavior” to judge you on.

New credit

Research has demonstrated to the credit companies that people who take out a lot of new credit at one time pose greater credit risks than those who have not taken out new credit lately.  The “new credit” factor incorporates, for example, the number of recently opened accounts you have in proportion to older accounts and the number of times you’ve recently applied for new credit.

Types of credit used

This factor considers the types of debt you have - installment debt (like a mortgage) and revolving debt (like credit cards).

Why does it matter?

Your credit score will affect not only whether you’re able to qualify for a mortgage, but also the rate you can get.  The following table is an example of how much less a person with a higher credit score might pay each month:

 

Source: MyFICO.com

On a 30-year fixed, $150,000 mortgage, a person with the highest credit score would pay $150 less every month - and $54,133 less over 30 years - than a person with a fair (620-639) credit score.

Clearly, having a higher credit score pays off.  At the beginning of the year, I blogged about how to boost your credit score.  Check out those two posts to learn how to boost a poor credit score (or maintain a good one!).

What do you think?  Click on the “Comments” link below and join the discussion!