Keep an Eye on Your Credit Score

In the mortgage game, many potential borrowers simply shop around for the best deal, and simply compare the rate quotes that lenders offer them. This approach, however, is somewhat passive, as it ignores one very important step: researching and improving your credit score. In light of the housing and credit crises, banks are relying increasingly on the credit score as a risk metric, so it’s crucial that you understand how the process works.

While every lender utilizes credit scores slightly differently, there is still a consistent relationship between the strength of the score and the “competitiveness” of the mortgage. In other words, one lenders might have 5 interest rate tiers which correspond to five credit score levels. Other lenders might have 3 tiers, or 10 tiers. Still other lenders might have minimum credit score requirements for certain types of mortgage. But the fact remains, the higher one’s credit score, the better/cheaper the mortgage is.

The credit score formula evaluates payment and credit history, utilization, new loans, types of credit in use, and the age of accounts. Generally speaking, your credit score will be highest if you pay your bills in time, have a small amount of debt (but not zero debt) relative to your credit limits, and have older and fewer sources of credit.” While dozens of different credit scoring formulas have been developed, the Fair Isaac Corporation’s FICO score has long been the industry standard. The exact formula is a closely guarded secret.

As part of the Fair Credit Reporting Act, you are entitled to view your credit score free once a year. Unfortunately, this rule might be doing more harm than good, since the free score that you can expect to receive probably isn’t your FICO score, but a score calculated using the specific reporting agency’s proprietary formula. Sometimes, there are wide disparities between different companies’ scores, such that the number you receive may not be entirely useful. Still, it’s important to review your credit report itself for errors, and to file a complaint if you discover any.

If your credit score is lower than you want/need, there are a couple steps you can take to improve it, most of which are self-evident. Namely, pay off any outstanding balances and cancel any credit cards that you aren’t currently using. In addition, have yourself removed as an authorized user on any cards that you don’t use since delinquent payments on such cards (by other authorized users) could negatively affect your credit. At the same time, don’t worry about consolidating debts under fewer cards, since this won’t meaningfully affect your credit score. Also, be advised that (sometimes arbitrary) cuts in credit limits can negatively impact your score because they increase your utilization rate.

While it may take years for such these measures and other responsible borrowing practices to result in an improved score, you could see a slight bump in only a few months. If there’s one particular blip on your credit score, it doesn’t hurt to submit a letter of explanation to the mortgage lender, in which you make it clear that extenuating circumstances (i.e. job loss, illness, personal issues) caused a temporary interruption in an otherwise seamless history of good behavior.