With files from Jaclyn Tersigni
Beacon? FICO? You will most likely have heard one of these bizarre terms at some point during your home buying process and wondered what they meant and how they affect the mortgage rate you get. To avoid any disappointment, it’s best to get up close and personal with your financial profile ahead of time, anticipating what might hurt your chances at approval.
Here’s a breakdown of common credit score terms, and a few tips to help you improve yours before applying for your mortgage.
Top tips to improve your credit score
Credit scores in Canada measure a borrowers’ credit risk based on a valuation of their financial history including details on credit cards, loans, mortgages, credit and payment history. A favorable credit score is an important factor in applying and securing the mortgage of your choice. It also makes it easier for an individual to get credit cards and loans on favorable terms, sometimes even with instant approvals. The higher your score, the lower the interest rate! The difference between a good and bad score can increase the cost of a loan by 3% or more. It is wise to start working towards a high credit score earlier on so you can reap the benefits of lower mortgage rates later on.
In Canada, credit scores are generated by three private agencies – Equifax, Trans Union and Experian. Though all 3 bureaus offer FICO (Fair Isaac Credit Organization) credit scores using the formula developed by Fair and Isaac, each has given it a unique name. Equifax calls it the Beacon Credit Score, Trans Union calls it FICO score and Experian calls it the Fair, Isaac Risk Model.
To keep yours in check:
1. Review your credit report at least once a year
- Equifax offers a complete credit score report for $23.95, or an online viewing option for $15.50
- TransUnion offers a full credit score report for $14.95 or a simplified version for $7.95
2. Contact your creditors or send letters the credit reporting agency to have errors on your credit profile corrected
3. Apply for credit only when you need it
4. Keep balances below 50% on your credit cards
5. Pay off non-mortgage debt on time as quickly as possible – if your debt levels are too high, create a payment plan to reduce your balances or look to consolidate this debt
6. Remember not to close accounts even if they are not used often – you can lose valuable points for this in the current evaluation system
TransUnion offers a Homebuyer’s Checklist which may be useful if you’re searching for a home.
Understanding Your FICO Score
What comprises a FICO score? “There are five components,” says Anthony Sprauve, senior consumer credit specialist for FICO. “Payment history (35 per cent), credit utilization (30 per cent), length of credit history (15 per cent), new credit (10 per cent) and types of credit used (10 per cent).”
- 35% of the total score is based on payment history
- 30% is the amount owed and the available credit
- 15% is for length of credit history
- 10% is for types of credit used
- 10% is for search and acquisition of new credit and inquiries
It is important to understand that different lenders set their own policies and tolerance for risk when making credit decisions, so there is no single “cutoff score” used by all lenders.
Are you in the red zone?
A red flag-raising applicant is “someone who has defaulted on their loans and/or credit cards or has repeatedly missed payments and has maxed out their credit cards,” Sprauve says.
A recent survey of mortgage professionals by FICO revealed what raises flags when it comes to mortgage loan applicants. Fifty-nine per cent of respondents said “high debt-to-income ratio” was their top concern, followed by “multiple recent applications for credit” (13 per cent) and a “low FICO score” (10 per cent).
An ideal applicant, according to Sprauve, looks something like this: “someone [who] pays all of their bills on time every time, keeps their credit card balances below 30 per cent of their available credit and only applies for new credit when they need it.”
It’s easy to see why lenders use these to evaluate prospective borrowers!
Other factors that affect your credit score
1. You’ve been looking for credit in the past year
If you’ve been recently been seeking credit, this is evident on your credit file based on the number of inquiries in the past 12 months. Research shows that consumers who are seeking new credit accounts are riskier than consumers who are not seeking credit.
There are both credit and non-credit inquiries on the report and the score only considers those related to credit applications. Inquiries such as your bank reviewing your account or you requesting a copy of your own report are not considered.
The scores can identify “rate shopping” so that one credit search leading to multiple inquiries being reported is usually only counted as a single inquiry. It’s been reported that for this to occur the person making the inquiry must use Equifax’s “mortgage code” when requesting your credit score (ie. “FM” is in your Equifax member number).
For most consumers, a few inquiries on your credit file has a limited impact on FICO scores.
Do inquiries drop my credit score?
A common misperception is that every single inquiry will drop your score a certain number of points. The impact of inquiries on your score will vary depending on your overall credit profile, and it can drop anywhere from 5 to 20 points on the first mortgage inquiry, but this is different for every case.
Inquiries will usually have a larger impact on the score for consumers with limited credit history and on consumers with previous late payments. The most prudent action to raise your score over time is to apply for credit only when you need it.
2. You have a short credit history
Age of your credit on revolving or non-revolving accounts also affects your credit score. Revolving accounts are credit cards such as Visa, MasterCard, or retail store card that allow you to make a minimum monthly payment and “revolve” the remainder of their balance over to the next month.
Non-revolving accounts include cards such as American Express and Diners Club and must be paid off in full each month.
Research shows that consumers with longer credit histories have better repayment risk than those with shorter credit histories. Also, consumers who frequently open new accounts have greater repayment risk than those who do not.
If you can maintain low balances and make sure your payments are on time, your score should improve as your revolving credit history ages.
3. Non-mortgage debt is too high
Consumers with larger credit amounts have a greater future repayment risk than those who owe less, resulting in the score measuring how much non-mortgage related debt you have.
The total outstanding balance on your last credit card statement is generally the amount that will show in your credit bureau report. Even if you pay these off in full each month, your credit bureau report may show the last billing statement balance.
Paying off your debts and maintaining low balances will help to improve your credit score. Consolidating or moving your debt into one account will usually not, however, raise your score, since the same amount is still owed.
Bankruptcy on the credit report is a borrower’s worst nightmare, as it stays on record for almost 10 years and reduces your score by 200 points or more.
4. Not paying off your loans
If you have installment loans and owe money on them, this does not mean you are a high-risk borrower. Paying down these installment loans is very positive as it shows that you are willing and able to manage and repay debt, and a successful repayment history is good for your credit rating.
One measurement is to compare outstanding loan balances against the original loan amounts. If you took out a $1,000 line of credit 1 year ago and still owe $925, this shows that you may be having trouble paying off the debt. Generally, the closer the loans are to being fully paid off, the better the score. This metric has limited influence on the FICO score.
Paying off loans on a timely basis reflects well on your credit score, but if you really want to improve it, try to pay the loans, (especially non-mortgage debt) as quickly possible.