Article Written By: Ryan McElveen
Credit is one of the most important, and one of the least understood, facets of our global economy. Consumer credit allows for greater consumer spending, in the form of home purchases, auto purchases, personal loans, and credit cards. Leverage, however, multiplies both the upside and downside of the risk-reward parity. Too much leverage can be credited for the increase in the percentage of Americans with “poor” FICO scores below 600, from 15% to over 25% in the past couple years, now representing a group 43 million strong and counting according to the Fair Isaac Company. Compound this with stricter mortgage underwriting and you have less demand. Excess foreclosures and short sales add to the supply side of the equation, whereas more supply and less demand in economics inevitably leads to price reductions.
And now to Mr. Homebuyer. Mr. Homebuyer realizes that rates and prices are at extreme lows and likely will not stay there much longer. If Mr. Homebuyer has bad credit, how does Mr. Homebuyer effectively take advantage of such a rare opportunity? What EXACTLY is a “FICO” score and why is it important?
To understand this concept, one must first understand credit reporting. As we begin using credit, we also begin establishing relationships with the creditors that extend this credit to us. These relationships are documented by the creditor, and are reported by your creditor in most cases to a credit bureau. The rationale is that by documenting your history, current and potential creditors will best be able to manage you as a borrower. As credit bureaus collect and store your information into files called credit reports, they sell this information to creditors, for credit evaluation, and third parties. The major credit bureaus are Experian, TransUnion, and Equifax, along with notable mentions Innovis and PRBC.
The Fair Isaac Company developed a formula, which they co-branded/licensed in slight variation with each credit bureau, that is intended to predict your probability of defaulting in the future using a scale from 350 to 850, the higher the number the lower the probability of default. This formula is an algorithm which, once understood, proves extremely useful in playing and winning the game of credit scoring and getting that mortgage or auto loan.
The formula they use is roughly portrayed in this pie chart:
Understanding that “roughly portrayed” is the key word here, this is where the FICO algorithm gets interesting…
Your FICO score is not dependent entirely on what you do because you are guilty by association. The Fair Isaac Company separates all the credit reports into groups, comparable to indexing, based on two factors: your oldest open account and your average account age. This means that the older your oldest open account is, the better your group/index will be rated, and the better your FICO scores will be. The same concept applies with the average account age except on a lesser scale. This is why closing out a very old credit card you may not be using will lower your FICO scores. In my personal experience, I have seen individuals add as many as 100 points to their FICO score simply by adding themselves as authorized users to old yet active credit card accounts that a relative or spouse has. Keep in mind that opening up a new account will lower your average account age and paying off an account entirely, excluding credit cards, is treated by FICO scoring as equivalent to closing the account; in other words, finally paying off a 30 year mortgage, especially if it is your oldest account, will surprise you with a lower FICO score.
As a real estate broker and owner of CredNet, I have spoken with and counseled many Mr., and Mrs., Homebuyers. Over the years I have compiled a list of common misconceptions which I feel are significant in improving anyone’s chances of fulfilling the American dream of homeownership:
CredNet’s Top 5 Credit Misconceptions
- I checked my credit at Experian/TransUnion/Equifax and my credit score is X. My banker said it was Y. Why doesn’t my banker have an accurate credit score? If you are using a credit monitoring service that offers you your “credit scores”, read the fine print. If it’s not a “FICO” score, which is used by 90-95% of major lenders, than you are paying for a modeled credit score. Each credit bureau has taken advantage of laws like the FCRA, or the Fair Credit Reporting Act, to confuse you into buying their worthless versions of “credit scores”. Experian, for example, has the most popular credit monitoring program, ads for which you may have seen or heard with the catchy “freecreditreport.com” slogan, and they call their version of a credit score a “PLUS” score.
- I should pay off or settle my bad debts? Paying off a debt and removing it off your credit reports are two different functions. The more important of the two is always removing it off your credit reports since creditors look at your credit reports. So how do you remove it? Medical collections, for example, fall under the jurisdiction HIPAA, the Health Insurance Portability and Accountability Act, which often allows you to remove these off your credit reports through formally disputing the item and without payment of the item itself. The same tactic could also be employed for any collection account, as they are all regulated by the FDCPA, or the Fair Debt Collections Practices Act. In a last resort scenario where all else fails, settling or paying off the account should only be pursued once a pay-for-delete agreement has been reached or it will continue to remain and hurt one’s credit, albeit with a “closed”, “settled”, or “paid-in-full” status. If the item is especially old, such a payment made without deletion often results in lower FICO scores because newly reported information effects one’s credit with much greater weight.
- I should pay off credit card accounts with a higher interest rate (APR) and pay more than the minimum payment each month? FICO scoring looks at your credit card utilization in a very different way than you and I. The optimal percentage use overall, which is calculated by taking your credit card “balances reported” divided by your credit limits reported, is 7%. Using less than, or more than, 7% overall will lower your FICO scores, although less than 7% would be advisedly better. Keep in mind that your “balances reported” and your current balances are different: “balances reported” has to do with when your creditor reports your balance to the credit bureaus. Knowing when this is, as simple as calling your creditor and asking, will allow you to manage your credit utilization rate better, especially for someone whose credit card usage is on and off throughout the month. Charge cards, which American Express is notorious for, may not report a credit limit and, therefore, can have a greater negative impact when holding a balance as it will have to be offset by other credit card limits. The number of credit cards you have which have balances, and the utilization on each, also affects the FICO scores, although to a much lesser degree than overall utilization. Paying more than the minimum payment each month, while fiscally prudent, is irrelevant as it is not used in your FICO score calculation. A HELOC, or Home Equity Line of Credit, will be treated as a revolving account the same as a credit card, although certain bureaus, like TransUnion, allow these to be treated as installment loans under certain circumstances (i.e. >$30k HELOC).
- I should not make any inquiries into my credit? First, let’s discuss the difference between soft inquiries and hard inquiries. Soft inquiries are those that are made by you, the consumer, into your own credit report, or they can be inquiries made by creditors for marketing purposes, a preapproved credit card offer being case in point, and lastly those made for other non-financing purposes (background, employment, tenant screening, etc.). I always recommend to my clients that they “opt-out” of soft inquiries made for marketing purposes by going to www.optoutprescreen.com or calling 1-888-5-OPT-OUT, each of which are mandated by the FCRA for consumers who do not want their credit file information sold to third parties. Hard inquiries, on the other hand, are inquiries that are made for the purpose of obtaining credit. Although they stay on your file for two years, the only inquiries that effect you are those that were made within the last 12 months. The more recent the inquiry, the more it will be weighted towards your score. The more inquiries you make within the last 12 months, the less each additional inquiry will hurt. I do not, however, suggest going wild with inquiries. Whenever you are looking to obtain credit, employ a technique called “Rate Shopping” – so long as the hard inquiries you initiate are coded the same (i.e. mortgage loan for home purchase inquiry), each one that you make within the last 45 days will only count as one inquiry. This does not work for revolving accounts, such as credit cards.
- Credit repair doesn’t work? Credit repair can and does work for most people. There are a select few who will have difficulty getting their credit repaired due to the nature of their situation. Although we’ve had some success, federal tax liens, child support obligations, and student loan delinquencies are among the most difficult of items to resolve. Setting the right expectations is crucial to ensuring customer satisfaction. It is rather unfortunate that credit repair companies that do not perform quality work exist as the industry as a whole receives a stigma. Doing a quick Google search of the company, checking the Better Business Bureau, or talking to friends and family who have successfully ventured into and out of a credit repair program, are great first steps to ensuring you are not being scammed.
Ryan McElveen is the owner, founder, and Chief Executive Officer of CredNet Corporation, a credit repair and real estate services company in Los Angeles. A real estate broker with a Master’s Degree in Business Administration from Pepperdine University, Ryan has found a passion in helping a large underserved market understand credit and the strategic paths to homeownership. Since its inception in 2007, CredNet has become well-known by motorists and regional finance professionals with its catchphrase: “It’s Not Just Credit Repair. It’s 1-800-CredNet.” If you would like to learn more, please visit: www.crednetusa.com.