To many of us, credit scores are a mystery. And in reality, the formula for determining credit scores actually is a mystery, but we can still learn key principles about credit scores that we can leverage when buying our dream home. (Haven’t found that dream home yet? Start here).
Credit Scores Measure Risk
First, a brief background on credit scores. The primary formula for determining borrower’s credit scores was originally developed by the Fair Isaac Corporation in 1989. FICO carefully keeps the specific formula unknown to prevent consumers from rigging the system. The score was designed to predict the likelihood that a consumer would go 90 days or more past due on a payment in the subsequent 24 months after the score was calculated. The higher the consumer’s score, the less likely they would go 90 days past due in the subsequent 24 months. Today, three big credit bureaus– Experian, TransUnion, and Equifax–call the shots. Each provides their own FICO score and develop their own individual report on you.
The formula is still a secret but they have released five key factors in developing the score:
- Payment History – Have you made payments on your debt on time in the past?
- Amounts Owed – How many lines of credit do you have, and how high is the balance on each?
- Length of Credit History – How long have you been using credit?
- New Credit – Have you opened several credit accounts recently?
- Types of Credit Used – What combination of credit cards, retail accounts, installment loans and mortgages do you have?
Less risk means a higher score
At the top of the spectrum, the perfect credit score is 850. It’s a unicorn of a score and nearly impossible to achieve as many factors need to work out perfectly for it to happen.
In the middle of the road, the nationwide average at 695. The average experienced a steady climb between October 2013 and October 2014 and now appears to be reaching a plateau. 695 is a good enough score as 660 and above will probably qualify for a loan.
Way down at the bottom of the scoreboard is 300, the lowest possible score. This is well below the the lowest score to have a reasonable chance to qualify for a loan–500. With a score of 500, you still have a chance to qualify for an FHA loan, but you may need the help of a good agent.
The bottom line is, as Anthony Sprauve, director of public relations at FICO says: “If you have a FICO score above 760, you’re going to be getting the best rates and opportunities.” If your score is below 620, you should wait to buy a home and instead focus on raising that score; it could save you tens of thousands.
A higher score means lower interest
If a borrower has a low credit score, the lender will charge a higher interest rate because the borrower is a higher risk. The difference in the likely interest rate between a 760 and a 620 could be only 1.6 percent. That may not sound like a lot, but on a 30-year mortgage of $200,000, the 620 score would pay over $68,000 more.