5 credit score misconceptions that hurt borrowers even as ‘credit gap’ disappears
After years of caution, lenders are increasingly in growth mode. Data from a new survey issued this July by FICO and the Professional Risk Managers’ International Association show that lenders expect consumer credit levels to grow during the second half of 2013, for two different but related reasons. First, lenders are more optimistic that consumers will be able to repay new debt and avoid delinquencies on existing debt. Second, lenders see consumers as increasingly optimistic and ready to take on more credit obligations.
This is good news for the economy. For consumers, the “credit gap” between available credit and desired credit has all but disappeared. For businesses, the improved credit market means consumers have more access to funds for purchases. And in the housing market, a more robust credit market helps increase the flow of transactions because more people are applying and qualifying for mortgages.
However, a stronger credit market doesn’t mean it’s any easier to qualify for a mortgage. From our perspective as community bankers serving the residential mortgage market, we regularly see situations where avoidable problems keep would-be homeowners from qualifying for mortgages or receiving the most attractive interest rates. Often the problem is the credit score. A lower credit score (and therefore a higher interest rate) can cost homeowners thousands or even tens of thousands of dollars over the life of a mortgage.
Yet there are so many misconceptions about credit scores, and in this case, what you don’t know can definitely hurt you. Following are five common misconceptions about FICO scores, which are the most commonly used credit scores in the mortgage industry. Each misconception is matched with the relevant facts and tips on how to achieve and maintain a higher score.
Misconception 1: Checking your credit report causes your score to fall.
Fact: Checking your credit report has no impact on your score. Checking your own credit is a “soft inquiry” that’s treated differently from inquiries made by lenders during a credit application process. Those lenders’ inquiries are “hard inquiries,” and it’s true that too many of those can affect a score. (However, if you are shopping for an auto or car loan and concentrate those inquiries within 30 to 45 days, that won’t affect your score much or at all.)
Tips: Reviewing your credit report regularly is important, but you don’t need to pay for expensive credit-monitoring services. Just take advantage of the free reports already available to you. Every four months, visit www.annualcreditreport.com. Each time, request a report from one of the credit bureaus: Experian, TransUnion, or Equifax. Each is required by law to provide you with a free copy of your credit history once each year, upon your request. By getting one every four months, you’ll be able to monitor your credit history on a regular basis.
When you review your credit report, look carefully for three types of errors: (1) incorrect information, such as payments shown as late that were made on time; (2) unfamiliar addresses or variations of your name, which may mean your information is mixed with someone else’s; (3) credit inquiries for loans you never applied for or debt you never took on.
If you discover errors, contact the relevant credit bureau in writing, using certified mail. If you suspect identity theft, contact all three bureaus immediately so a fraud alert can be placed on your file. Also visit http://FTC.gov/idtheft for a guide to critical next steps. The most difficult type of error to correct is bad information about someone else, so take errors seriously and follow the resolution process to completion.
Misconception 2: Employment status and income affect your credit score.
Employment status and income are important criteria in the mortgage application process, but they play no part in your credit score. Age, marital status, ethnicity, and religion also have no relationship to your score. Here are the actual components of the FICO score:
- Payment history: 35%
- Length of credit history: 15%
- Amounts owed: 30%
- Types of credit used: 10%
- New credit: 10%
The overall score, which takes all these categories into account, ranges from 300 to 850. Each of the three credit bureaus may have a slightly different FICO score for each person, because they have slightly different information in the credit history. (That’s another reason it’s a good idea to check your report from each of three bureaus on a rotating basis.)
Tips: The percentage breakdown shown above illustrates what’s most important for improving your credit score. Payment history is the most important. Any delinquencies, collections, or public record items will affect scores. A 120-day delinquency will affect the score more than a 30-day delinquency. Similarly, recent late payments will have more negative effect than those from years ago. There’s nothing you can do about the past, however. If you’ve missed payments, then focus on getting current now.
Misconception 3: Closing unused credit cards will help raise your score.
Fact: Even when you pay off and close a credit card, that information remains on your credit history. Furthermore, by closing credit accounts you lower your overall credit availability, which in turn raises the percentage of available credit you’re using on your other cards, which may affect your score.
Tips: To maximize your credit score, keep your existing accounts open but keep your balances low. Aim to keep all accounts below 50% of the applicable credit limit.
Also, don’t apply for any new credit accounts shortly before a mortgage application. Only apply for credit when you need it. Generally, it’s not helpful to open credit accounts simply to increase credit availability.
Misconception 4: Co-signing loans doesn’t put you at risk as much as your own borrowing.
Fact: Co-signing student loans and other debts can be disastrous. If you co-sign on a student loan, your score is likely to decrease at the time you co-sign because of the increased risk. It will rise again when the student makes on-time payments. But just one missed payment can significantly damage your credit score. That missed payment may affect you for up to 10 years.
Tips: Most people are completely unaware of the danger of co-signing on any loan. Be prudent. If you must co-sign, take steps to help ensure payments are made on time. Be aware that bank risk professionals are wary of student loans. In the survey referenced above, the student loan category was the only one where lenders expected increasing delinquencies over the next six months.
Misconception 5: Working with a credit counselor will negatively affect your score.
Fact: Reputable credit counselors can provide valuable assistance to people getting back on their feet. Credit counseling will not, on its own, negatively affect your score. However, be aware that any loan modifications or charge-offs will affect your score significantly. Homeowners should know that any loan modifications (such as a short sale of a home at a lower value than the debt outstanding) may affect scores as much as foreclosures.
Tips: If you need help, do seek reputable help. Also be aware that the most important aspect of reestablishing a good credit score is making payments on time, over the course of years. In that sense, there are no shortcuts. If you pay off a collection account, that information still remains on your report for seven years. But on the other hand, eventually those items will be removed. Even bankruptcies will clear off your credit report after 10 years. For some, it may just take time.
Credit markets are more robust now than any time since the financial crisis. But lending standards for mortgages remain high and are likely to stay high. If you are in the market for a mortgage or loan, be especially sure to monitor your credit history in order to maintain your score and can take advantage of its value available in the marketplace.
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