Obviously, we apply for credit/loans for more reasons than purchasing a home.

We finance cars, computers, take out student or “signature” loans, etc. We as a nation take out so much credit, often times opening accounts within minutes at virtually any large retail chain, that our spending habits demanded a system of objective, standing scoring for our credit worthiness. What’s the tool for the job? None other than infamous credit score.

A credit score is a number, which ranges from 300 to 900, that basically gives a lender (be it credit for a mortgage loan, car, or credit card) a simple ‘lend/don’t lend’ answer when you apply for a loan. When applying for a home loan, many other factors besides your credit score are taken into account to determine your lending worthiness, such as savings reserves and employment history, however, for lower risk “instant” credit, like a credit card, one can see why a standardized system of scoring would be extremely convenient – perhaps too convenient.

How it’s determined

The score is derived from your credit report, a report that tracks your payment history on all your debts, such as credit cars, car loans, property taxes, and even child support or alimony. In a nutshell, the better your payment history (the more often you pay your debts on time), the higher your score, simple enough. However, simply not having any debts at all could actually result in a lower score. In general, the scoring system is based on the idea that a lender would look for two qualities in a borrower:

• Willingness to pay
• Ability to pay

While the ability quality is probably calculated more on your amount of cash reserves, your willingness to pay is evidenced by the number of debts that you’ve paid on time. For example, someone with a history 5 debt obligations who’s paid every bill on time and maintains a small balance on each debt would probably score better than someone who only has one card on record with a zero balance. Why, because the first borrower has demonstrated a clear willingness to repay debt – they have a strong history of punctual payments. While the second borrower hasn’t shown any negative qualities, they haven’t shown a clear record of anything – they haven’t demonstrated that they can manage a significant debt obligation.

While there are several scoring methods, the most commonly used is known as FICO – an acronym derived from the Fair Isaac & Company. Fair Isaac is an independent financial firm that invented the scoring method and software that’s been the standard meter with banks, lenders, and insurers. Experian, Equifax, and TransUnion (the Nation’s three credit bureaus) worked with Fair Isaac in the early 1980s to come up with the scoring method.

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The Nitty Gritty

While there are many widely accepted theories of how credit scores are determined, the exact formula is perhaps a secret as valuable and closely guarded as the recipe for Coca-Cola. One could only imagine if lenders knew how to trick the scoring agencies – one could apply the formula and qualify for just about anything! (of course, they would be obligated to that debt, but a nation of heavy consumer credit-score hackers would certainly be more difficult to manage at the checkout line)
Specifics aside – here’s an overview of how your FICO score is determined*:

• 35% of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how timely) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection, any bankruptcies, etc. When these things happened also comes into play. The more recent, the worse it will be for your overall score.
• 30% of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25% or less of their limits.
• 15% of the score is based on the length of time you've had credit. The longer you've had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.
• 10% of the score is based on the number of inquiries on your report. If you've applied for a lot of credit cards or loans, you will have a lot of inquiries on your credit report. These are bad for your score because they indicate that you may be in some kind of financial trouble or may be taking on a lot of debt (even if you haven't used the cards or gotten the loans). The more recent these inquiries are, the worse for your credit score. FICO scores only count inquiries from the past year.
• 10% of the score is based on the types of credit you currently have. The number of loans and available credit from credit cards you have makes a difference. There is no magic number or combination of types of accounts that you shouldn't have. These actually come more into play if there isn't as much other information on your credit report on which to base the score.

What’s my score mean?

Again, while a mortgage lender takes many considerations into account, the following scale is an approximate indication of how your score place you in the eyes of a lender.

• Poor: 300 – 600
• Fair: 620 – 680
• Good: 680 – 720
• Excellent: 720 and above

Exactly how much of a factor your score will play in determining what loan amount and interest rate you qualify for, (banks generally weigh scores higher than brokers) here are what you may find when your score is obtained at application:

Poor: Expect to pay additional points at closing and/or a higher interest rate. Generally, you won’t qualify for “A” paper loans, and unfortunately the national average interest rate that you read in the paper won’t apply to you. You may have trouble qualifying for credit cards or auto loans.

Fair: Depending on the lender, you may qualify for “A” paper. Expect to pay industry standard fees and qualify for close to standard rates. You’ll score well in the eyes of Credit Card companies, auto dealers, and retailers.

Good: You’re “A” paper material. Unless you have poor employment history, little reserves, or an unsettled account on your report (a delinquent payment or you’ve been reported to a collection agency), expect to qualify for industry standard interest rates and fees. You probably get several Credit Card applications in the mail per month!

Excellent: Consider yourself worthy of “A+” paper. Borrowers with scores in this range show a long payment and employment history, and have often had several past home loans. Excepting any credit problems and that you have sufficient reserves, expect to receive discounts on your interest rate. Also, you’ll probably qualify for stated-income or “low-doc” loans without any additional fees. Your signature alone with worth money – expect to qualify for high credit limits with auto dealers, Credit Cards, and “signature” loans.

(*Source: http://money.howstuffworks.com/credit-score.htm)

However, don’t let a fantastic score fool you - you should always get pre-approved. Not only will a pre-approval determine if there are any other considerations that may affect your qualification, you’ll also determine what you can actually afford. After all, qualifying for an $800K purchase price and budgeting $4,000 a month solely to your mortgage are two different things entirely.