Credit & Credit Scoring
By Patrick Schwerdtfeger
Credit scores play an incredibly important role in our lives yet few of us truly understand where they come from and how they’re calculated.
Credit scores are provided by three primary repositories: Experian, Equifax and Trans Union. These are basically huge databases that house information on almost everybody in the country. And how do they get all this information about us? Well, creditors (like card, automobile and mortgage companies) are always looking for information about potential clients; people like you and me. They get that information from these repositories but in exchange, they agree to provide data about all their customers back into the same databases. Almost all of your providers report your payment history into these databases and every time you obtain a new account, that account is reported under your Social Security Number.
Credit reporting in its current form is still relatively new and a lot of people, particularly in the older generations, are still unaware of all this information being held about them and their histories. My own parents, for example, were shocked when I told them such databases exist and the extent of information available. And it’s amazing the number of things in our lives that are affected by our scores, so an understanding of the things they look for when calculating our scores can be incredibly beneficial for those who want to optimize their scores.
Let’s start with a definition. What is a score actually trying to reflect? Well, the exact thing a score intends to predict is the probability you’ll have a 90-day late on a trade account within the next 24 months. That’s what they’re actually trying to predict. And as you can imagine, there are a number of things that increase the probability you’ll have such a late payment and those are the variables that make up your score. Now, the formulas and algorithms being used these days are incredibly complicated and they change periodically as well, so it’s impossible to lay out the exact components and their respective weights. But the basic structure is well documented and that’s what we’ll focus on here.
First, you should know that the median score in this country is right around 720. That means half the population has a higher score and other half has a lower score. It’s actually just a bit higher than 720 – about 722 is the latest I’ve heard. Pretty high, huh? It’s true. So the average person in this country has pretty darn good credit. In fact, only about 1% of the population has a score below 500. That means at least half the population should be in A-paper mortgage programs. It’s true that income and assets also play a major role in mortgage underwriting but at least from a perspective, most people should be in A-paper mortgage programs. Sadly, that’s not the case.
Many Mortgage Brokers gently nudge their clients DOWN the ladder of loan programs because it makes their lives easier. The guidelines are looser in what’s called "Subprime" programs so you don’t have to get as much documentation and it’s easier to get an approval. In fact, what you want is someone who’ll instinctively push you UP the ladder and try to get you into the best possible program you qualify for, even if it’s a bit more tedious. And with a 720 score, you’re off to a great start.
We should also mention that there are actually 10 different score cards that calculate scores. They’re each designed to evaluate a different set of circumstances. Are you young with only very recent history? If so, that’s one of the score cards and it focuses on different metrics than the score card for someone who’s had a 30-year history. Do you own a house and have mortgage debt? That’s reflected in different score cards as well. Have you ever declared bankruptcy? That’s an entirely separate score card also – and the strictest one of the bunch, by the way. There’s no question that you should avoid bankruptcy however possible, because it’ll put you on the bankruptcy score card for seven to ten years – and that’s not a good place to be. Bankruptcy should be the absolute last option.
And lastly, before we look at how the scores are calculated, we need to discuss the fact that each of the three repositories has its own score. We’re all familiar with the FICO score – everybody refers to the score as the FICO score, but that’s only Experian’s version of the score. Equifax has the Beacon score and Trans Union has the Classic score. Although they’re all quite similar, they’re each calculated slightly differently. It’s also important to understand that our creditors don’t necessarily give our information to all three repositories so they may each have slightly different information, resulting in different scores. In the mortgage business, we always have to use the middle score – not the highest, not the lowest, but the middle score.
Okay. So for your score, the single biggest component is your Payment History. It accounts for a full 35% of your total score. That’s more than a third. It’s a huge component so making your payments on time is the best thing you can do to keep your score healthy. Within Payment History, the repositories look at (1) recency, (2) frequency and (3) severity. If you’ve had two 30-day lates in the past six months, that’s a lot worse than two 30-day lates a year or two ago. In fact, they consider the most recent six months the most, followed by the past two years and then anything after that. The more recent, the bigger the effect on your score. Obviously, a 60-day late is worse than a 30. And if you’ve had a 90-day late, that’s the worst there is. Remember that THAT is exactly what they’re trying to predict. So if you’ve had a 90-day late in the past six months, you can rest assured your score took a beating as a result.
The second biggest component of your score is Revolving Balances; that’s the outstanding balances on your tradelines – your cards. Your Revolving Balances account for 30% of your total score. So, between your Payment History and your Revolving Balances, we’ve already covered 65% of your total score. These are the pillars of your score – by far, the most important.
Obviously, the higher your balances, the lower your score. It makes sense if you think about it. If your balances are really high, there’s a higher probability you’ll have a 90-day late in the next 24 months. And the repositories calculate your balances on both individual accounts as well as aggregated across all your accounts. So while there may be some small benefit spreading your balances around on different cards, it won’t make a big difference overall. The best thing you can do is pay your balances down.
Its worthwhile noting your score has absolutely NO memory. So if you’ve got a high balance today and you pay if off tomorrow, your score could be substantially higher tomorrow. It’s also worth noting your creditors do NOT report your balances every day or even every week. Most report once each month and the day they pick may OR may NOT coincide with your
statement date. So the balance reflected on your report may NOT match the balance reflected on your most recent statement. Anyway, your score is calculated at the time it’s requested so it’ll reflect the information in the database at that moment in time. If your balances are high, your score will be lower. If your balances are low, your score will be higher.
The next biggest component is your History. It accounts for 15% of your score. So between your Payment History, Revolving Balances and your History, we’ve now accounted for a full 80% of your score. Your History looks at the age of your oldest account and the number of new accounts opened recently. Again, the logic makes sense. If someone’s opening a ton of new accounts, there’s no history to see how he or she will deal with all these new accounts. So with these new unknowns, the risk level goes up and the score goes down. It’s never a good idea to open a bunch of new accounts. From the perspective of your score, it’s good to have between five and seven accounts but if you don’t have that now, don’t try opening them all up at once.
Next on the list is the Type of Credit. It accounts for 10% of your score. Type of looks at both open AND closed accounts. It looks at the type of you use and how many accounts of each you have, or have had. The three major types of are (1) revolving, (2) installment and (3) mortgages. But there is one subcategory under the label of revolving that hits your score harder than the rest, and that’s the finance company installment accounts. These accounts are the "no payments for 12 months" type of accounts. You know the ones. Buy now, pay later. The repositories know what they are as well, and they know the risk of a 90-day late increases when someone goes out and buys all kinds of furniture and flat-screen TVs without having to pay anything for it. Avoid these types of promotions whenever possible.
The last component of your score is the Number of Inquiries. Inquiries account for the final 10% of your score. Now, there are two types of inquiries. We all get tons of card offers in the mail. Well, each of these companies checked our before sending us their offers. But don’t worry; they’re not considered in our score. They’re called Soft Inquiries because we didn’t request the credit. Many people worry when they get these offers that all these inquiries are reducing their scores but that is NOT true.
The second kind of inquiry is a Hard Inquiry. That’s where you signed something authorizing a company to check your because you’re applying for a new account. So every time you apply for a new card or try to buy a car or a house, those are all Hard Inquiries. Only these inquiries are considered in your score. Generally speaking, you should limit the number of inquiries to 5 to 7 per year. Yeah, that’s PER YEAR. 5 to 7 per year. Your score will look at the most recent 12 months and each individual inquiry can affect your score by 5 to 15 points, depending on the type of applied for.
Now, when we’re shopping for a car or a mortgage, we frequently consult with multiple places before we make our final decision. We might visit three or four different car dealerships. We might speak with two or three different Mortgage Bankers before submitting our loan application. The bureaus know this and they’ve adjusted their algorithms accordingly. For auto inquiries, you can have an infinite number of inquiries within a 14-day window and they will all count as a single inquiry. For mortgage inquiries, you can have an infinite number of inquiries within a 45-day window and they’ll all count as a single inquiry. So don’t worry about speaking with multiple people. That, in itself, will not reduce your score.
The science of scoring already extremely complicated and it continues to evolve. Even now, your score is an amazingly accurate assessment of your character. That’s one of the reasons income and asset documentation has become less important. Bottom line; if you have a good score, lenders know there’s little risk you’ll let them down.
Patrick Schwerdtfeger is a licensed Mortgage Banker located in Northern California. He is the creator of Beyond the Rate, a detailed and candid podcast series providing essential backstage information for California homeowners.
