Two Credit Uses That Will Hurt Your FICO Score
I’ve never seen someone with a perfect 850 score and it is unnecessary to strive for it. From a mortgage lending perspective your best loan terms occur at 740 so anything above that does not get you a lower interest rate.
Your credit score does not tell the lender whether you will make your loan payment on time. Instead, the score is a numerical indicator of the statistical risk of you defaulting on your loan relative to other borrowers. The lower your score the higher the odds (and they increase rapidly) you will default on the loan or make your payments late. Even a person with a perfect score of 850 has some risk of defaulting.
Lenders design their loan programs and pricing models around credit score ranges. The FICO ranges vary greatly among loan programs so there are only broad generalizations I can make. For example, you might only need a 620 FICO score to purchase a home using an FHA loan, but you’d need at least a 680 to use a Conventional loan with only 5% down. In addition, the interest rate and fees you pay will increase sharply if your credit score is below 740.
The home lending industry switched from making subjective credit decisions to utilizing the FICO scoring system in the mid 1990s. When I started in the business lenders still had the Underwriter make the determination if someone met the minimum credit requirements. Over the years I’ve reviewed thousands of credit reports and can share a couple of the most critical, and often misunderstood, areas in which you can improve or harm your credit score.
By far the biggest mistake I see are people who close their unused credit accounts. Very early on in the implementation of scoring systems consumers were negatively impacted by having too much available credit. Underwriters would assume, with some validity I would argue, that if you had $50,000 in available credit lines then someday you’d use it. So lenders initially recommended you close your unused accounts to reduce the available credit. What the lending industry and consumers quickly discovered was that closing accounts had a very negative impact because one of the biggest components of the scoring models is your “history” – literally how long you have had good credit. If you had four credit cards which had been open 15 years you would have a high score. There is 15 years of credit data upon which your score can be supported. However, if you had a fifth credit card account that was only 2 years old and subsequently closed the four old ones all of a sudden you would look like a brand new credit user to the scoring system. The scoring models can’t analyze closed accounts.
Related to closing accounts is the belief that only having one or two credit cards is the best idea. And it would be, if you kept your total outstanding balances on those two cards very low. What I see frequently on credit reports is two maxed out credit cards. The scoring model really does not like this. It “looks” to the system like you are a heavy user of credit and are now in trouble because you are maxed out on your cards. Someone with two maxed out cards at $5,000 apiece will score much worse than someone with five credit cards with $1,000 each. For the best scoring results keep your outstanding balances to no more than 30% of the total credit line of each account.
There are many other things you can do to impact your credit score but these are the two I see that occur frequently and managed effectively would have the largest impact on your score.
As always, if you have any questions just give us a call!
Michael has 21 years’ experience in the lending industry. In that time he’s directly helped over 1,400 families finance the purchase of a new home or refinance an existing loan. Rebecca has a CPA background in auditing financial institutions which brings an incredible resource to First Priority Financial. They are licensed to help families in the states of WA and CA. If you, or anyone you know, needs help with a home loan call 509-252-9151 or send an email to Mike Mullin