How to Prepare Your Credit for a Mortgage Application

A lot of the people that come to hear me speak or contact me for a credit consultation have the same goal, to purchase a home or refinance the current mortgage loan they have.  Usually they contact me after they have discovered that their current FICO score is not high enough to accomplish that goal.  Since this is a common theme, I had the idea to write a few helpful tips for people in this situation.  Please feel free to share this with your friends or clients that might benefit from this.

Understand the score you checked

For clarity sake let us start by me telling you that the score you are probably using as the basis for determining whether or not your score is good enough or needs improvement is most likely not an accurate score.  All of these websites and services that sell you or allow you to view your credit score are not the same score your mortgage person will utilize.  Be careful putting too much emphasis on the value of these scores.  In my opinion if you want to get an idea of what your FICO score might be, two of the more accurate and free websites are CreditKarma.com and CreditSesame.com.  Again these are not true FICO scores (which is what your mortgage will be accessing, but they are usually two of the most accurate as a gauge).  Most of the other sites out there I never recommend to people because they typically are too far off in the range or model they use. 

Take Action 

One of the fastest and easiest things you can do to improve your score is to understand the importance of your credit cards on your credit report.  More specifically the balances that you are currently carrying on those cards.  A very important factor to your FICO score is the percentage of revolving credit you are utilizing at the time of the report.  A simple tip, the lower the balance on your credit cards the better when it comes to this.  If your goal is to improve your FICO score in the next few months start by making your main goal to pay off your credit cards. 

Stop using your credit cards

Now that you have paid off or paid down your credit cards you want to get the benefit of those lower balances on your credit report.  This can’t be accomplished if you keep charging on those cards every month.  All credit cards have cycles; there are different days where the credit card issuer reports the balances on your cards to the credit bureaus.  This date is not the same as the due date.  To get the score benefit of this action, after you pay the cards off, stop using them (do not close them) then wait 45 days before you apply for your mortgage.  This way you will actually get the score benefit of having these cards paid off!

You’re not done yet

Once you have been told that you are approved, that doesn’t mean it is time to start using the credit cards again or applying for new credit.  A lot of lenders pull a new credit report late in the process.  You do not want to jeopardize your loan because you decide that a new couch would look nice in the house that you don’t own yet.  Keep the balances at $0 and don’t apply for anything until after the loan is closed!

I understand that everyone’s situation and credit is different.  These are just a few simpletips that would benefit the large majority of people that I talk to.

Short Sale Changes

Recently I read an article about not only changes being made in the mortgage industry, but also how those potential changes might affect credit scores.  Since the article lists some credit “facts”, I feel obligated to address it further.  The article is short so I have listed it here and will follow up with a few opinions after:

Nondelinquent Borrowers Soon to Be Eligible for Short Sales

Daily Real Estate News | Wednesday, October 24, 2012 

Mortgage giants Fannie Mae and Freddie Mac have issued new rules, which will take effect Nov. 1 that will allow short sales for underwater borrowers who have never missed a mortgage payment. Previously, Fannie and Freddie allowed only home owners who had missed payments to qualify for a short sale.

Eligible borrowers under the new rules will need to show a hardship to qualify for a short sale, however. Hardships may include unemployment or a death of a spouse. 

Inman News points out one potential flaw to the new rule, however: The nondelinquent home owners who undergo a short sale will likely take just as big a hit to their credit score than if they had missed loan payments and gone into a foreclosure. 

“Under current national credit reporting practices, those nondelinquent borrowers are likely to be treated the same for credit scoring purposes as severely delinquent owners who go to foreclosure after months of nonpayment, or who simply toss back the house keys and walk away in strategic defaults,” writes Ken Harney for Inman News. 

Credit agencies use no special coding to indicate that a short sale was without delinquency. Therefore, home owners could see their credit scores drop 150 points or more after the short sale.

However, officials at the Federal Housing Finance Agency, which oversees Fannie and Freddie, told Inman News they are “in discussions with the credit industry” to explore ways to fix the credit score problem for those who haven’t missed a payment but undergo a short sale. 

The good news is that when the new rule change goes into effect, this will now give people an even greater incentive to take this course of action rather than just allowing the property to be foreclosed on. 

The bad news is a few of the credit facts listed in this article are wrong or at best misinterpreted.  With all due respect to Mr. Harney, who is a much esteemed writer, I believe the source of where some of his credit information came from was a little off, specifically paragraph 3 and his quote following that in paragraph 4.  

To completely understand the debate about short sales vs. foreclosures and more specifically the impact on the FICO score we need to understand a few things.  

First -what happens prior to the closing/sale date?

With a foreclosure we know that the person will have multiple late payments listed on the credit report for that account.  With a short sale (especially with this new rule) there doesn’t have to be any late payments. This is great news because the absence of 30, 60, 90+ day late payments on an account is better for your FICO score than if those were present on the account history.  One of the biggest arguments that people used to have is that it was basically impossible to get a short sale negotiated without being delinquent first.  Now with this new change that issue should be eliminated.

 For this reason, if a person does not become delinquent on the mortgage prior to the short sale being completed this action would be better for the FICO score than a foreclosure.

Advantage- short sale

Second- what happens after the closing?

When there’s a foreclosure the account will be listed as such or it will say “charged off account.” Any derivative of this is bad and will hurt the FICO score.  With a short sale the article is correct; there is no special way that a lender can mark the account as a short sale.  Since that is not an option the lenders have the choice of how they report it.  Most commonly lenders report it as “settled for less than full” which in the eyes of your FICO score all means the same… it is bad! With that being said, since a short sale is not an option for credit reporting, the one wild card that can come into play is if the lender just simply marks the account as “paid”.  If this were to happen it would be much better than being reported as a foreclosure.

Advantage- short sale

The last part of this debate hasn’t been covered. Not only is the FICO score measuring how delinquent someone’s account is, it’s also measuring the time since that incident.  Meaning the older that negative is, the less it hurts your score.  With a short sale you can help to speed up the process, which will help an individual’s FICO score recover quicker.  

Overall if this new rule does in fact come into play it is a positive thing for struggling homeowners that need to get out from under a property they can no longer afford.  Keep in mind homeowners also want to do everything they can to lessen the credit score damages that will become associated with any of these actions. 

Spending to improve your FICO score?

Have you ever heard or been told that when trying to rebuild or improve a credit score “it is a good idea to charge up your credit card, leave the balance on the card for a few months then pay it off?” Followed by, “repeat this cycle a few times because it will show that you are a responsible consumer and manage your credit well,” and by doing this overcomplicated system the end result would net in a better FICO score?  If you haven’t, you just haven’t been listening to enough people that are always quick to explain how you can improve your credit score.  After almost 5 years of being a Certified Credit Scoring Expert and reviewing thousands and thousands of credit reports it is one of the most common tips that people share with me that someone else gave them prior to them talking with me about how to improve their score.  Since it is such a popular piece of advice I have decided to address it for everyone.

                This advice stems from a category of your FICO score that is most commonly referred to as your debt ratio.  In simple terms it measures the percentage of debt that you currently have (balance) in proportion to the limits available on revolving accounts or the opening balance on installment debt, with the highest weight being placed on the revolving accounts.  Revolving accounts and more importantly how you use those accounts have been found to be a highly predictive factor to the FICO score, thus the reason they are so important.  The more predictive something is, the more important it should be to us as consumers if our goal is to improve or maintain a good FICO score. 

                With that as our basis, this is where the common advice takes a turn from being “helpful” to flat out wrong and destructive information.  The measurement that is calculated is the percent of revolving credit being used at any given time compared to the limit.  So here is a simple math exercise; if I have one credit card and the limit is $1,000 but I currently have a balance of $500 then I am using 50% of my available credit on that card, which means my revolving debt ratio is 50%.  The first thing to understand as a rule of thumb is the lower your revolving debt ratio the better.  In fact the best percentage you can have to maximize this piece of your score is between 1 and 2%. 

                If we understand the mechanics of how this number is calculated, we just need to then understand a few basics of how credit reporting works.  Credit scores and credit reports are two different things.  Credit reports are just complied by a bunch of data that exists about us.  Credit scores happen when that data from the credit report is evaluated and analyzed to give some type of score or rank.  The FICO score is measuring the statistical chance of a consumer being 90 days late or more in the next two years. 

Credit scores are real time information based on non-real time data.  The area where this presents the largest issue happens to be in credit card balances.  The reason this can be such a problem happens to be one of the reasons why the advice being discussed here is total garbage.  The due date on your credit card is not the day your balance is reported to the credit bureaus.  The date your balance is reported is a day most commonly referred to as the cycle ending date or statement ending date.  If I had one credit card with a $500 limit and every month I charge it up to the max, then wait for the bill to come and pay it off in full my score would be suffering all because of the timing of when I pay my bill!  Credit card balances do not get updated daily, this is further proof that credit reports are full of out dated information.  Also credit scores are evaluating my credit report at that moment in time; they do not look back over the history of our credit card balances.  It is all about what is owed compared to the limit at that moment in time in which a score is requested. 

Following this very popular and bad advice not only will help you be successful at lowering your FICO score, you will be in credit card debt plus it will cost you money as you will be paying interest charges on that revolving balance!

Here is a better approach to improving your credit; have a credit card and on a monthly basis charge 10% or less of the limit, wait for the bill to come and pay it off.  Sometimes the simple approach will not only result in better results, it will save you money, time and frustration!

What you bought is not what it you think it is…

If you have ever felt confused by credit scores, don’t feel alone!  Everywhere you go from the internet, to television ads, to radio commercials you will see some type of product that you can purchase to learn your “credit score”.  All kinds of companies are now making a big push to have us as consumer’s purchase our credit scores so that we are aware of what is being reported about us.  While I can appreciate the awareness that this brings to people about the importance of our credit score, the part that really irritates me is that all these companies are really doing is confusing people even more. 

                Just about every time I do a public speaking event I have someone bring up an example and it usually is always about the same.  It goes like this, “I checked my score online, then I went to a mortgage broker and was shocked when I was told that my score was significantly lower than the score I just bought a day or two earlier online, why is that?”  The answer that I give is always the same; the score you bought online is a credit score.  It is considered a credit score because it does take the information from your credit report, evaluates it somehow and then gives you some type of credit that reflects your creditworthiness.  That is where the similarities end and confusion begins!  The main difference is just about every “credit score” you purchase online has two main differences from the FICO score.  First, usually it has a different score range, for example in the classic FICO score the range is 300 to 850.  Some of these other scores have ranges from 500 to 950! The second main difference is the criterion that is being analyzed.  FICO has certain things they use in their model and each of those has different values.  These other scores can’t use the same values as FICO does so for that reason not only do they have a different score range, they also evaluate different information and assign different values to that information. 

                Having said all that, at this point in time the FICO score is the overwhelmingly favorite score used by all industries to determine your creditworthiness.  So unless that changes, in my opinion it is a waste of time to spend any money to see what a score looks like or follow any advice to improve that score if it’s not even a score that any lender is ever going to use anyhow to determine if you can qualify for a loan or not.

                A lot of people understand the difference between a “credit score” and FICO score, but one other thing that can drive people nuts is when they do their homework and are educated about the differences so they purchase their FICO score on the internet.  They are doing the right thing by at least purchasing the proper type of score, but then again are surprised when the scenario above is played out again.  How can this happen, “I pulled my FICO score, my mortgage person also pulled my FICO score but there is a big difference between what I pulled and the score the mortgage broker pulled?”  What we are dealing with here is FICO has created not only industry specific scoring models, but also there are different versions of that model being used!  Currently there are over 49 legitimate FICO scores being used all with differences between each of them.  In other words depending on what type of credit you are applying for and who you are applying with you could have 49 different FICO scores!

                The best advice I can give you with this, understand the best you can what the FICO score is looking for and evaluating, then do the best you can to maximize all those areas of your score.

“Joint credit”…what does it really mean?

The world of joint credit can be a little confusing.  Mainly because there are different types of joint credit and each one carries a different list of circumstances and responsibilities.  Before you enter into the world of joint credit with another person, it will be helpful if you know exactly what you might be agreeing to.   Here is a list of some very important things you need to know before agreeing to any type of joint credit.

1.       There are multiple types of shared credit.

Many people use the term “joint credit” but depending on the bank or lender’s opinion that can mean a lot of very different things.  There are three different types of shared credit.  They are:

Joint Credit: With this agreement you are a full partner on the account. You filled out or at least signed a credit application.  

What you might not know: With this type of account you are 100% responsible for the bill (not 50 percent).

Authorized User: You are able to use the credit, but you have basically no financial liability to repay the debt.  You never filled out or signed an application.  Someone else filled out the application, obtained the credit and is responsible for the repayment of the debt; they just gave you charging privileges.

What you might not know:  If the account holder doesn’t pay, some lenders may try to come after you for the charges that you were responsible for.

Co-signer: You are signing to be responsible for the entire bill, but the loan or credit account is in someone else’s name and you can’t use it.  The other person will receive the bills, and you may or may not have access to account information. 

What you may not know: If the person that you co-signed for defaults,  pays late or misses a payment, that information can be included in your credit history!

2.       How joint debt is reported on your credit report.

Understand there is no such thing as a joint credit history.  This means the entire account history and balance of the account appears fully on your credit report.  It is not broken up to only show what you are responsible for.  This means it doesn’t matter who makes the charge or who was responsible for a late payment, both parties are responsible and their credit report will both fully reflect those actions.

3.       Divorce courts can’t reassign joint debts.

Two spouses that have multiple joint credit accounts will have to decide who will be financially responsible for each one of those debts.  This is a stipulation that is rendered by the divorce courts as part of that process.  It however does not change the view of the account with the creditors.  Even though the court says one party is responsible financially for a debt, if that person fails to pay, the other person is still liable.  A credit card agreement is between the borrower and the lender, and divorce courts don’t have the authority to alter that agreement.  

4.       With joint credit both people are affected equally.

If a joint credit account is good (low balances, paid off in full, high credit limit, no late payments), it helps all the parties involved.  But if it’s not healthy (late payments, rolling balances, maxed out credit line), everybody’s credit suffers.

Final advice: be careful when it comes to joint credit.  Make sure you understand all the potential ramifications associated with your involvement in the account before you agree to anything.