Because most lending today is internet based, an accepted credit standard is needed to put everyone on the same page. As a result, credit scoring was developed and has become standard in the industry, though sometimes it’s controversial and misunderstood.
FICO scoring, named after Fair, Issac and Co., the California-based firm that developed the software, creates a computer generated numerical grade (typically 400 to 850) that predicts a lender’s risk in loaning you money. The higher the score, the better risk you are to get a loan for a car, house or whatever.
For example, if you pay your bills on time and haven’t maxed out your credit cards, you probably have a score in the 700s. However, if you have a few thirty-day late payments and your credit cards are nearing their limits, your score can drop to the 500 or the 600 range.
Your FICO score can change day to day as your creditors (mortgage lenders, banks, credit card issuers, or other credit sources) report to the credit bureaus on how well you meet the terms of your obligations.
Three companies, Equifax, Experian and Trans Union, dominate the credit reporting business. Since these agencies use different models for credit scoring, it’s common for a lender to use reports from all three to establish your credit worthiness. Because each reporting agency gets its information in a slightly different way, it’s not uncommon for your credit score to differ between 20 and 50 points on each report. That’s not always a problem, because mortgage lenders typically update discrepancies or reconcile differences in reports to get a current picture of your credit for better or worse. If there are problems, the lender may ask you to write a short letter to explain your side. Should you have to write one of these letters, keep it shot and stick to the facts. Applicants sometimes get carried away and include their family history.
Scores of 700 and above typically qualify you for the best interest rates and terms. If you have a credit score under 700, you may still be able to get a loan, but interest rates and closing costs are likely to be higher.
During the days of runaway sub-prime loans, it appeared as if lenders would approve anyone who could fill out a loan application. They tied borrower’s credit scores to the prevailing interest rates – and added in variable or low introductory rates to make them more appealing. This resulted in many foreclosures when interest rates shot up and house payments soared after the adjustment periods. The lesson learned from this is that if you have a lower credit score, it’s better to clean up your credit rating so that you can qualify for good interest rates and terms before buying a home.