The science behind your credit score

WASHINGTON — If you’re thinking of buying a house, there’s one number that’s more important than all the others.

It’s not your salary. It’s not your savings-account balance. It’s not even the price of the house.

It’s your credit score.

In three digits that score tells lenders just about everything they say they need to know about how likely a person is to pay back a mortgage loan in a timely manner. The more risk potential homebuyers pose, the less likely they are to get a loan with the lowest possible interest rate and the best terms. It’s the rare lender who looks only at a credit score, but a low score will put you in a bad position.

What people don’t know is that they can goose their credit scores relatively quickly with a few small steps, lending and credit experts say. But first they must find out what their scores are and understand what they mean.

Most consumers neglect to do that, surveys have shown. About 97 percent of people have no idea what their credit scores are, and 86 percent did not check their credit reports last year even though doing so is free, according to an informal survey by Credit.com Educational Services in San Francisco.

“Many people don’t know where they stand and they don’t know that they can improve their standing,” said John Ulzheimer, the group’s president. “Some think their credit is good and it’s not, and others think their credit is bad and it’s not.”

Ryan and Colleen Kelly fell into the latter category. With $30,000 in credit-card debt, they figured their chances of getting the mortgage they needed to finance the home they wanted would be slim.

But they recently closed on a new town house in Olney, Md., that they could buy with an interest-only mortgage that requires a very low monthly payment. Their plan is to use the money they save each month on their mortgage to pay down their credit cards.

“I definitely thought our credit is worse than it is,” said Ryan Kelly, 29, an administrative assistant at the National Institutes of Health. “We don’t get late payment calls or creditors calling. But we still carry a balance on our credit cards, and I was concerned that would affect our credit score.”

It did. But not as much as they expected because the couple had taken steps in previous years, perhaps unwittingly, that offset the potential damage, said their loan officer, Connie Echeverria of Prosperity Mortgage, an affiliate of Wells Fargo Home Mortgage.

For starters, their credit cards had been open several years with an excellent record of on-time payments, which helps assure lenders that the couple will not fall behind on house payments.

“We, as lenders, want evidence that you have been … [dealing] with creditors for a substantial amount of time so we can see that you are capable of repaying debt,” Echeverria said. “That’s what shows us that you are a good risk.”

Because many homebuyers do not understand that concept, they often rush to close longtime accounts in good standing before applying for a mortgage. In effect, that weakens their credit scores. Open credit cards do not hurt your credit score. What hurts is having credit cards that are nearly maxed out.

“If you’re going to close credit cards, do it in a mindful way,” Echeverria said. “Do not close the old ones with high limits and low balances. Close the young ones with low limits. You can’t do it willy-nilly. It’s a science.”

Origin of FICO

Science is what helped shape the credit-scoring business into what it is today. The nation’s most widely used scoring formula, called FICO, was developed by Minneapolis-based Fair Isaac Corp. and became commercially available in 1989. FICO was adopted widely by mortgage lenders in the late 1990s after Fannie Mae and Freddie Mac endorsed it.

The nation’s three largest credit-reporting agencies — Equifax, TransUnion and Experian — use FICO software to calculate credit scores. They then sell the scores to lenders that underwrite car loans, credit cards and mortgages.

While FICO can rate most Americans with fat credit histories, others are more difficult to peg. Among them are college students, consumers who pay their bills with cash and people who haven’t tapped into their credit for a long time.

Fair Isaac estimates as many as 50 million people fall into this group, which is difficult to score fairly using the standard method. In those cases, some lenders allow borrowers to submit nontraditional proof of their creditworthiness, such as utility bills, child-support payments and even Book-of-the-Month Club memberships, said Fair Isaac spokesman Craig Watts.

For everyone else, there are standard FICO scores, which range from 300 to 850. The median is 723, meaning half of consumers score better and half score worse. The higher the number, the stronger the rating.

It’s unlikely that each credit agency would give the same score to the same person. That’s because the agencies collect their information from different creditors. Even when they collect from the same creditors, they update their records at different times.

To get a more accurate picture, mortgage lenders pull FICO scores from all three agencies. Most then base their lending decisions on the middle one of the three scores, said Ulzheimer of Credit.com, who has worked for Fair Isaac and Equifax for a total of 15 years. If a couple is applying jointly, then six credit reports and six credit scores are pulled.

Information that does not appear on the credit report is not factored into the FICO score. That includes a person’s salary and savings. The theory is that income is not a strong predictor of creditworthiness.

“It’s a measurement of your ability to make a $5,000 house payment each month, not whether you will actually make the house payment,” Ulzheimer said. “So a doctor with a seven-figure income does not automatically score higher than someone who works at a retail store and makes $20,000 a year.”

In FICO’s estimation, whether someone pays their bills on time is such a good predictor of creditworthiness that payment history makes up 35 percent of a FICO score. That’s followed by the amount owed, the length of credit history, the types of credit involved, and new credit opened.

Financial trouble

Catherine Cavanaugh took a hit on all those fronts when she got into financial trouble a few years ago, stopped paying bills and ruined her credit rating.

In 2000, she filed for personal bankruptcy protection, and her Silver Spring, Md., town house was foreclosed on later that year. Department stores stopped extending her credit. Landlords refused to rent her the apartments she wanted. She could not secure a cellphone account.

Frustrated and scared, Cavanaugh gathered her outstanding bills and began arranging payment plans with her creditors. (Cavanaugh’s tip to the financially troubled: Contact your creditors before they report you to the credit bureaus.)

Then two months ago, Cavanaugh attended a homebuyers-education workshop sponsored by HomeFree-USA, Freddie Mac and Bank of America. She began working with a credit counselor, who gathered paperwork showing that Cavanaugh had paid her creditors and sent the documents to the credit bureaus.

“I just assumed that the credit bureaus knew I was paying off my bills and everything was getting fixed automatically, but it wasn’t,” said Cavanaugh, 58, a receptionist at Holy Cross Home Care and Hospice.

Weeks later, Cavanaugh’s FICO score was up to 662 from 408, she said. Now she has one closed credit card left to pay off. She has two open credit cards, both of which she pays on time.

The longer Cavanaugh stays on track, the less damaging her bankruptcy is to her credit. Most negative information on a credit report has a life of seven years, though some matters stay on it indefinitely, such as delinquent student loans.

But for the FICO score, the most critical period is the most recent one to two years — in other words, don’t forget to pay your $80 cellphone bill, and don’t open up a Macy’s charge card a few months before applying for a loan.

“So much of this was unnecessary,” Cavanaugh said. “There’s so much I didn’t know.”

Like many consumers, Cavanaugh had not pulled her credit report or score until recently — something that credit experts encourage everyone to do at least once a year. Federal law allows consumers to access their reports with each one of the major credit bureaus free once a year by logging on to www.annualcreditreport.com. Some states allow for additional free reports. For a few extra dollars, the bureaus also calculate scores for those who ask, though not all of them sell the FICO brand.

But many people shy away from this critical first step because they’re intimidated by it, said Marcia Griffin, president of HomeFree-USA, a nonprofit group that helps educate low-to-moderate-income people about homeownership. Anyone who wants to own a home needs to get that credit report in hand and contact a lender, a real-estate agent or a nonprofit group to talk about what comes next, she said.

When you get the report, the first step is to review it closely. Look for errors and possible fraud, such as identity theft. Credit bureaus can fix these problems if you have the records to back up your claims.

You may also discover that positive information that could raise your score has been omitted — for instance, the payment record or credit limit on one of your credit cards.

By law, if you find what you think is an error, the credit bureau must investigate the matter (generally within 30 days) and provide the person affected with the written results within five days, according to Freddie Mac. “Remember, your credit doesn’t have to be perfect. It has to be decent,” Griffin said. “The credit report will tell you how close or how far you are from your goal. You have to start looking at your financial house before you start looking for your home.”