The Mortgage Professor: Some Questions About Credit Scores

By Jack Guttentag
The Mortgage Professor.

Q: “Can I get a mortgage with a credit score of 450?”

A: If you get one, it won’t be a mortgage you want. Credit scores are calculated using a variety of models that have small differences between them and generate similar but not identical scores.

The range of scores in most models is 300 to 850, with a score below 620 considered sub-prime, and a score of 450 marking the subject as a deadbeat who no honest lender will touch. If you have equity in your home, however, there are some predators who will lend to you in the expectation that when you default, they will find ways to shift the equity to themselves. Don’t bother asking me who they are.

Q: “What should my target credit score be if I want the lowest possible interest rate on a mortgage?”

A: It depends on where you start, and on how much time you have to raise your score.
If you begin with a 620 and have 18 months, shoot for a 660 which will drop the rate by about .375 percent (say 4.625 percent to 4.25 percent). If you begin with 680 and have 18 months, shoot for 720 which will drop the rate by about .125 percent. Some lenders will drop the rate by another .125 percent at 780, but you can’t get there from 680 in 18 months.

Note that credit scores are calculated from mathematical models, of which there are many designed for different types of users. Mortgage lenders won’t ordinarily use the same model as auto loan lenders, and some mortgage lenders use different models than others. Different models will generate different scores, and while the differences are small, your target score should include a margin of error of at least 5 points. This would make the targets discussed above 665 and 725.

Q: How does one manage credit cards so as to generate the highest possible credit score?

A: Avoid delinquent payments and maintain low utilization ratios. Delinquent payments reduce your score. Eliminating the delinquency does not restore your score to where it was, it merely prevents a further decline. Delinquencies stay on your record for 7 years, although their force will gradually weaken as on-time payments come in.

Shoot for low utilization ratios, below 33 percent on all your cards. The utilization ratio is the outstanding debt relative to the maximum amount of debt that the credit grantor has set on that card. For example, if the balance on a card is $2,500 and the maximum balance is $5,000, the utilization rate is 50 percent.

A card holder can reduce his utilization ratio by reducing his balance, and also by increasing the maximum balance. If a borrower has had a good payment record, the maximum can often be increased simply by asking.
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If your card issuer does not report a maximum, your score will be calculated on the assumption that the highest balance ever reached in that account is the maximum, when in fact it could be well below the maximum. This raises your utilization rate (and lowers your credit score) for no good reason.

If a card has no reported limit, you can either request that the limit be reported, or terminate the relationship. Alternatively, you can shift all your balances into this account temporarily so that the highest balance comes closer to the unreported maximum.

In addition, don’t have too many cards or too few, about 4 or 5 old cards that you actively use is about right. New cards can reduce your score. Avoid department store cards, which will reduce your score.

‘Will inquiries about my credit made by the lenders I am shopping reduce my credit score?”

They may unless you limit the number of inquiries that matter to one.

“Hard” inquiries made by vendors are potentially a negative item in the score, and the safeguards built into the system to avoid penalizing shoppers are not wholly reliable.

The only sure way to protect yourself is to order your own score, which is a “soft inquiry” that does not affect the score. You then provide this score to all the vendors you shop, indicating that they can check your credit when you are ready to authorize it.

This will reduce the number of hard inquiries to one, from the vendor you finally select.

“Should I pay off an old collection account before applying for a mortgage?”
Yes, and the sooner the better.

A lender will not accept an unpaid collection account on your credit report, so you will have to pay it off. But the payoff will temporarily reduce your credit score, and the sooner that happens, the better.

Paying off a collection account, like bringing a delinquent payment current, does not remove it from your credit record. As time passes, the impact on your credit score of an adverse item in the report gradually declines, because older information is less predictive of how good a credit risk you are than more recent information. But the adverse item does not disappear.

When a borrower pays an old collection item, the payment converts it from an old item with diminished weight into a current item with greater weight. As a result, paying an old item reduces the credit score. You want this to happen as early as possible so that the passage of time will diminish its negative weight in your credit score.

On August 7, 2014 the Fair Isaac company which develops the models used to calculate credit scores, announced that its newest model would ignore collection items that had been paid, and that medical collection items would carry a substantially lower weight.

The new model will become available before the end of the year, but mortgage lenders won’t adopt it until it is blessed by Fannie Mae and Freddie Mac, and nobody knows when that will be. For now, the best rule remains “Pay off collection accounts ASAP.”
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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