Credit Advice

Establish Credit To Buy A Home

Last weekend I visited with a young couple who was looking to be preapproved for an FHA loan so that they could buy a home.  Their excitement was apparent as we went through the application and discussed the different first-time homebuyer benefits and options that are currently available.  Unfortunately, the excitement soon dissipated when I pulled their credit report.  The couple thought that they had been able to build good credit history, but they were wrong.  The husband’s credit scores were below 500 and the wife had no credit scores at all.  The only items on their credit report were two recently opened credit cards that were maxed out and a couple of collection accounts.  The couple was disappointed to learn that they could not qualify for a mortgage at the current time and fearful that they would never be able to establish good credit.  Fortunately, we were able to design a plan to help them build their credit history and increase their credit scores.  I explained to them that, despite this setback, they are still only months – not years – away from home ownership.  It is critical that anybody who has a desire to buy a home knows how to establish a strong credit history.  Doing so properly will reduce your expenses and increase your buying power and earning capacity throughout your life.  So how is it done?

The following are some key steps to establishing excellent credit history and starting the path to home ownership.

Know What You Are Trying to Accomplish

If you fail to plan, you plan to fail.  For that reason, the first step is to know what a credit report is and how it is derived.  By understanding what the goal is, you can work to obtain it.  Some experts have advised that the ideal credit report will have a mortgage, an installment loan (such as an auto loan), and two to five credit cards (at least one from one of the major providers such as VISA or MasterCard) with low balances.  A credit profile such as this, if well maintained, will certainly result in a high credit score with time.  My experience has proven that a person should aspire to have a credit score over 720 because many of the mortgage banks reserve the lowest interest rates for borrowers in this category.  Once you understand what a credit report is and you have set a goal as to how to achieve it, start to execute your plan.

Know The Common Credit Qualifying Criteria

What factors are a lender going to look at when deciding to issue you credit?  On almost all loan applications – whether for a credit card or mortgage – banks want to see that you have the capacity to repay the debt.  So, if you don’t have credit history, a lender will look at your assets, stability, and income (or earning potential).

Assets. It is very important that you open and maintain bank accounts.  By doing so, you have documentation of your ability to budget and save, thus demonstrating financial responsibility.  I recommend that when you are starting out and choosing a banking relationship that you look for a local community bank or credit union.  Many times, smaller, customer-centric, institutions know you individually and not as just an account number.  Because of that, they may have lower banking fees and more flexible lending criteria.  You may have an opportunity to sit down face-to-face with your banker who will look at your total financial scenario and potential vs. having to apply by phone or internet to a faceless automated system that approve you only on your credit score.  Many local community banks and credit unions have lending programs designed specifically for people who are looking to establish their credit history because they want to gain your long-term business.  Just make sure that they actually report your loan information to the credit bureaus.

Stability. Many lenders want to see how long you have been at your current address and how often you move.  Frequently moving isn’t necessarily a reason to be declined (unless you are breaking leases and defaulting on contractual obligations), but stability does go a long way to compensate for a lack of credit history.  One of the key factors of stability is establishing sources of “alternative credit”.  For that reason, it is important that you try to create a history of documented bills in your name such as rent, utilities, auto insurance, phone or cell phone, etc (paying a friend or family member probably won’t do the job).  Although they typically do not show up on your credit report, they can be used by a lender to issue credit.  In fact, FHA guidelines will allow you to qualify for a mortgage even if you have no credit history and FICO scores if you can document three “alternative credit” sources with at least a twelve month history of on-time payments.

Income (or Earning Potential). Your income will be a key factor in establishing credit.  Lenders want to see that you have stable employment and sufficient income to repay the debt on top of your standard living expenses.  If you are a college student and you are not working, take advantage of the opportunity to apply for “student credit card” offers.  Lenders are willing to approve you based on your future earning potential and they are looking to capture your long-term business.  However, please understand that obtaining credit card debt that you max out or can not maintain is very bad and can seriously derail your opportunities to establish high caliber credit history.

How Do You Actually Get The First Accounts On Your Credit History

Utilize Someone Else’s Credit. The easiest way to start building your credit history is to utilize someone else’s credit that is already established.  If you know someone, such as a family member, that you trust (and they trust you), you can be added onto an existing credit card as a joint account holder.  This will include the credit card history into your credit report.  Obviously, there is risk in doing this.  If the person has previous late payments or suffers from more late payments, this information will go on your credit also.  The same applies to maxed out credit limits.  So, it could be a good and a bad thing; and therefore, you need to choose wisely.

Another way that you can utilize someone else’s credit is to have a co-signer.  Many times a bank will be willing to loan you money if you have a co-signer who has established credit history and can demonstrate financial stability.  The problem with this is that if YOU don’t make the payments, you are putting their credit at risk.  I currently have a client who is looking to buy a house but can’t until we repair his credit report.  A few years ago, his friend asked him to co-sign on an auto loan and then his friend let the car be repossessed.   Now my client has a repossession showing on his credit report.

This is how I was able to start building my credit.  The first loan I ever got was with my local credit union and my brother co-signed on a used car loan for me.  The credit union had a program that allowed me to refinance the car into my name only (removing my brother from liability) once I had made six on-time payments.

Department Store and Gas Cards. So, what do you do if you aren’t in college and you don’t have a reliable person that is close enough to you to add you as a joint account holder or to act as a co-signer?  Try applying for a department store card or a gas card.  It is much easier to get a department store card than it is to get a card from a major provider such as Visa or MasterCard.  However, I recommend that you keep a minimum balance (not a 0 balance, you need to create payment history) on these types of cards because their interest rates are very high.  Don’t be surprised if they reach up to 21% to 33%.  It is also fairly easy to get a gas card, such as Texaco, ExxonMobil, etc.  Just make sure that they report your payment history to any of the major credit bureaus.  If not, then it isn’t serving its purpose and you will just be paying high interest.

Be prudent and stick to a credit building plan.  Just because a company will approve you doesn’t mean that you should approve them.  You don’t need to have a large number of credit card accounts.  In fact, it could actually hurt you to have too many.  Too many inquiries and too many new accounts in a short period of time can drop your credit score.  Don’t use over 30% of your credit limit on any one card if you want the best credit-building results and never miss payments.

Secured Credit Cards. Another way to start building your credit history is by obtaining a secured credit card. A secured credit card is a type of credit card secured by a deposit account that you place with the card issuer.  Don’t assume that your payments can be taken out of your deposit.  You are still expected to make regular payments, as with a regular credit card, but should you default on a payment, the card issuer has the option of recovering losses out of the deposit.

The advantage of the secured card when you are trying to establish your credit history is that many offer approval with no credit check and most companies report regularly to the major credit bureaus. This allows for building of positive credit history.  With that being said, it is critical that you ensure that the issuer of the secured credit card that you select reports to the major credit bureaus.

Fees and service charges for secured credit cards often exceed those charged for ordinary non-secured credit cards.  Even knowing this, you must use caution when choosing your credit card issuer because many charge egregiously high application fees and annual fees.  Further, if you make your payment after the payment grace period, they may charge extremely high penalizing interest rates.  So, do your homework in advance.  As I recommended before, start with your local community bank or credit union.

You can also check out “the credit card search engine“.

Move Forward

Remember, now that you know how to be approved for credit, you must build credit with a plan.  It is crucial that you do not make avoidable mistakes as this will affect your buying power for years to come.

Here are a few last points of advice.

• Again, build with a plan.  I recommend that if you are starting from scratch, your goal is to try to open three credit accounts and achieve 12 months of payment history (without late payments of course) in an 18 month period.
• Don’t make to many inquiries and applications.
• Don’t use more than 30% of your limit on any one credit card.
• Don’t pay off your credit cards.  You should maintain a small monthly balance.  This may not be the most prudent financial advice, but good advice for establishing your credit history.
• Try to establish a mix of installment and revolving credit.
• Don’t pay late.

Good luck.  Soon you will have the necessary credit history to buy your first home and FHA mortgage loans are great for first-time homebuyers.

If you have any questions regarding establishing credit history how it impacts on your ability to obtain an FHA mortgage for your next home loan, please contact me today.

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At its heart, the FHA loan approval process is based on the philosophy that past credit history demonstrates most effectively a borrower’s attitude towards paying their bills and credit obligations.  Therefore, FHA underwriters are allowed to manually underwrite FHA loan applications and not be wholly dependent upon automated approval systems.

This also means that historically, FHA has allowed for their underwriters to approve files with lower credit scores if there are reasonable explanations for past poor credit performance and compensating factors.  In this fashion, FHA can provide loans to people with bad credit.  Unfortunately, as a result of the current housing crisis and high number of defaulted loans, most banks that purchase and service FHA loans have now adopted minimum credit score requirements that a borrower must meet in order to be approved.  As such, to take advantage of the many benefits that FHA loans offer, it is essential that FHA borrowers have an understanding of what a credit score is and how it is derived.

What is a Credit Score?

Basic Definitions:

Credit Score: A statistically derived numeric expression of a person’s creditworthiness that is used by lenders to access the likelihood that a person will repay his or her debts. A credit score is based on, among other things, a person’s past credit history. It is a number between 300 and 850 – the higher the number, the more creditworthy the person is deemed to be.

Credit Bureau: An agency that researches and collects individual credit information from banks, public records and other sources and provides it for a fee to creditors so they can make a decision on granting loans.

Credit Report: A detailed report of an individual’s credit history prepared by a credit bureau that includes – among other things – personal data, a credit score, a summary of credit history and detailed account information.

Credit History: A record of a consumer’s demonstrated responsibility in repaying debts. It consists of information such as: number and types of credit accounts, how long each account has been open, amounts owed, whether bills are paid on time and number of recent credit inquiries.  It also contains information regarding whether the consumer has any bankruptcies, liens, judgments or collections. This information is all contained on a consumer’s credit report.

Creditworthy: The measure of a borrower’s ability to repay debt.

I have found that a very precise summary of the above definitions is found in the verbiage of the “FACT Act Disclosure” that is provided to all mortgage loan applicants as part of the standard mortgage loan application.  The Fair and Accurate Credit Transactions Act (FACT Act) was enacted in 2003 and amends the Fair Credit Reporting Act (FCRA), a federal law that regulates, in part, who is permitted to access your consumer report information and how it can be used.  It says:

The credit score is a computer-generated summary calculated at the time of the request and based on information a credit bureau or lender has on file. The scores are based on data about your credit history and payment patterns. Credit scores are important because they are used to assist the lender in determining whether you will obtain a loan. They may also be used to determine what interest rate you may be offered on the mortgage. Credit scores can change over time, depending on your conduct, how your credit history and payment patterns change, and how credit-scoring technologies change.

Because the score is based on information in your credit history, it is very important that you review the credit-related information that is being furnished to make sure it is accurate. Credit records may vary from one company to another.

One or more of the following credit bureaus provided a credit score that was used in connection with your home loan application.

Experian
P.O. Box 2002
Allen, TX 75013

Phone 888-397-3742
Model Used:    Experian Fair Isaac
Range of Possible Score: 340 to 820

Trans Union
P.O. Box 1000
Chester, PA 19022

Phone 800-888-4213
Model Used:     FICORiskScoreClassic04
Range of Possible Scores: 300 to 850

Equifax Credit Information Services
P.O. Box 740241
Atlanta, GA 30374

Phone: 800-685-1111
Model Used: EquifaxBeacon5.0
Range of Possible Scores: 300 to 850

How is a Credit Score Derived?

Now you see that there are three different credit bureaus that report your credit history independent from each other and that they each assign you a credit score that can range from as low as 300 to as high as 850.  So how do they do it?  In the US, credit bureaus typically use a credit score model called the FICO system.  FICO uses mathematical algorithms and statistical models to create your credit score.  Although the exact formulas are not made public, the following components have been disclosed.

Payment History (35%): Your payment history is the most important category and has the greatest impact on your overall credit score.   Each month, as you pay your bills on time, it improves your credit score.  On the other hand, late payments it can have a dramatic negative affect on your credit score.  The more recent you are late, the lower your credit score and a history of late payments on several accounts will cause more damage than late payments on a single account.

A quick list of major derogatory (negative) items that can significantly lower your credit score are:

• Late payments over 90 days past due
• Any information in the public records section of the credit report.  This includes bankruptcies, tax liens, judgments, etc.
• Collection accounts
• Charge-Offs
• Repossessions
• Foreclosures
• Short Sales

Amounts Owed (30%): It surprises me how many people are not aware of the large role that “amounts owed” plays in the make up of their credit report.  For example, I had a borrower that I helped refinance last month who was shocked when he found out his credit score was much lower than he had thought it was.  He didn’t have any late payments so he thought his credit report was perfect.  I reviewed his credit report with him and saw that he had an $8,000 balance on his credit card with a $10,000 limit reporting.  This may not sound like a big deal, but after doing some maneuvering and getting the balance down his credit score increased 57 points in less than three weeks.  Instead of obtaining a mortgage at 5.75%, he was able to get an interest rate at 4.875%.

The two standard types of accounts that dominate a credit report are installment loans and revolving debt accounts.  Installment loans, such as car loans or mortgages, have set payments and terms, and the lower the amount that you owe relative to the initial loan amount the better.  Revolving debt accounts, like credit cards and lines of credit, have a greater impact on your credit score.  I have seen that once your balance exceeds 50% of your limit on a credit card, it starts to drop your credit score.  The higher you are to being “maxed out” or “over the limit”, the greater the drop.  If you are able to maintain the balance of your revolving debt accounts below 30% of their limits, your credit score will typically increase month over month.  Here is an interesting fact, if you want to increase your credit score, it is better to leave a small balance (again, under 30% of the limit) on your revolving account rather than pay it off.  This may seem counterintuitive to many financially prudent people, but credit companies like to see a history of maintaining debt and good payment history.  Therefore, an account with a small balance with a history of on-time payments will increase your credit score where as an account with zero balance will typically neither increase nor decrease your score.  Of course, this creates a level of risk that you may miss a payment.  Finally, having too much available revolving credit can also have an adverse impact on your credit score.

Length of Credit History (15%): The longer your credit history, the better it is for your score.  Also taken into consideration is how long it has been since you used certain accounts and the average account age of your existing open accounts.
New Credit (10%): The two things to consider here are the number of new accounts and new available credit and the number of recent inquiries that that appears on your credit report.  Statistics prove that opening too many new accounts in a short period of time increases the risk of default as it could lead to “spending sprees” or “debt pyramiding”.  If you need to open new accounts to establish (or reestablish) credit, a wise decision would be to open no more than one account every six months and no more than three accounts in a 24 month period.
Having too many inquiries in a short amount of time will have a negative affect on your credit score.  One thing to consider is that you can shop for the best deal.  Having multiple inquiries for the same purpose – such as shopping for a car – in a short amount of time (typically 30 days) is generally looked upon as one “hard inquiry”.

Types of Credit (10%):  Credit scoring models look for a healthy balance of installment debt, revolving debt, store charge accounts, etc.  Some experts believe that the ideal mix for the best credit score is a few credit cards with relatively high limits and only a small balance on one or two of them along with an installment loan with a spotless six-month payment history.

If you have any questions regarding credit scores and their impact on your ability to obtain FHA financing for your next home loan, please contact me today.

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