In the home buying process, when you apply for a new loan the lender will want to look at a variety of indicators to make sure you’re going to pay them back. These include your income, existing debt, and your job security (or how predictable your income is).
Perhaps the greatest indicator of how likely you are to pay off a loan is how well you’ve made payments on other loans in the past. To find out about your borrowing and paying history, lenders use credit bureaus–companies that aggregate information about you and sell it back to creditors.
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There are three primary credit bureaus that monitor consumer debt in the U.S. They’re called Equifax, Experian, and TransUnion. With your approval, a potential lender can access their database and see (almost always) all the loans you’ve opened in the past, and how consistently you paid them. This information comes in the form of two valuable tools: credit reports and FICO scores.
A credit report is a long list of all the loans you’ve ever opened, including who lent you the money, how much you borrowed, how much you still owe, and what payments you made (or missed). When they look at your credit report, lenders want to see a few key factors:
- What other lending institutions have trusted you enough to lend you money
- How many payments you’ve made late or missed completely
- How much money you can borrow compared to how much you currently owe (if you have a credit card with a $10,000 limit and you’ve only got a $2,000 balance, you seem more responsible than if you’ve maxed it out!)
- If you’ve ever defaulted on a loan, been foreclosed on, or filed for bankruptcy
The bank will pay the credit bureau(s) of their choice a few dollars to access your report. You’ll have to sign a document with your lender saying it’s okay for them to do this. By looking at your credit report, they can see all the loans you’ve opened, including the ones you’ve already paid off, and how well you made payments. They’ll use this information to determine whether they’re comfortable lending to you, and if so, what interest rate they’ll charge you.
Your FICO score is a single, three-digit number between 300 to 850 that quickly tells a lender what your credit risk is. 850 is the highest score possible, indicating that you’re extremely likely to make your payments based on past performance. On smaller loans, and even accounts with service providers like utility and telecom companies, your FICO score is the only thing a creditor will require.
What determines my FICO score?
Five key variables make up your total credit score, each indicating a certain aspect of how you borrow and pay back money.
- 35%: Payment history How well and how promptly you make payments on existing loans is the most heavily-weighted variable in the FICO formula. Have you defaulted in the past? Bankruptcy, liens, judgments, settlements, charge offs, repossessions, foreclosures, and late payments can severely hurt your FICO score.
- 30%: Debt burden The most well-known indicator of your debt burden is how much credit card debt you have compared to your credit limit. If you’ve spent every penny of credit available to you, you might seem riskier. The debt burden category also considers the number of accounts with balances, amount owed across different types of accounts, and the amount paid down on installment loans.
- 15%: Length of credit history If you’ve been borrowing and making payments for a long time, your score will improve. Obviously there’s no way to improve this except by living longer, and it’s often difficult for young people to access credit simply for this reason. FICO considers the average age of the accounts on your report, as well as the age of the oldest account. So if you still have that secured credit card you opened when you turned 18, keep it! It will help your score.
- 10%: Types of credit used Your score will improve if you have a variety of loan types, including installment loans (like a car payment), revolving (home equity line-of credit, for example), consumer finance (credit cards), and a mortgage. Lenders like to see you understand and have successfully honored different types of credit.
- 10%: Recent searches for credit Every time a lender does a “hard pull”, your FICO score is impacted for the worst. It means that you’re shopping for credit, which can easily be interpreted as taking on a significant, new debt burden. But there are several fail safes that will help you keep your score up. Learn about them here. A “soft pull”, however, which is done by you for verification purposes (see AnnualCreditReport.com), an employer, or someone wanting to send you “pre-approval offers” does not affect your score, and only shows up on the report you request, not the one a lender sees.