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Understanding Credit Scores…

March 7, 2011 by MSI

Over the past several years, due primarily to the economic conditions in the U.S., individuals have struggled to maintain or improve their credit scores, which are critical to their ability to make large purchases, especially homes and automobiles. Unemployment, reduced wages and eliminated bonuses, variable mortgages and increasing costs of consumable products have all added additional pressures to individuals and, for many, their credit scores have been impacted as a result.

So, what really is a credit score? It’s a number that represents an individual’s likelihood of repaying his or her debts. Banks and credit card companies use this score to evaluate their risk and, then as a result of that evaluation, they make the determination of whether or not to lend the money and at which interest rate. The most commonly used credit score in the U.S. is the FICOÒ score, which ranges from 300 to 850 and is determined by statistical calculations. While FICO will not release their exact formulas or the specific weights for each category behind their score, the have offered the following general overview:

• 35 percent of the score comes from the payment history
• 30 percent is derived from credit utilization
• 15 percent is impacted by the individual’s length of credit history
• 10 percent comes from the type of credit used
• And, 10 percent is determined by the recent searches or credit inquiries

Other occurrences which may have a significant negative impact on credit score are any monies owed, especially recently, because of a lien or court judgment and having one or more consumer finance credit accounts.

According to FICO, the median credit score in the U.S. is 723, with 60 percent of all scores falling between 650 and 799. Of course, a variation in credit score can significantly impact an individual’s ability to purchase a new home in terms of affordability due to the interest rate. An example provided by FICO demonstrates the impact.

For a 30-year fixed mortgage of $300,000 an individual with a credit score of 760 to 850 would potentially receive an interest rate of 4.645 percent, equating to a monthly payment of $1,546, while someone with a credit score of 620 to 639 would comparably receive an interest rate of 6.234 percent and have a monthly mortgage payment of $1,844. That is a difference of $298 per month and, over the life of a 30-year loan, it adds up to an astounding $107,280. And, remember, this is based on a $300,000 mortgage.

Credit scores are critical for consumers and especially potential home buyers, so it’s important that individuals understand where they stand and the specific influencers so that they can continuously work on improving their credit. It’s also important for companies to understand this potential challenge as it relates to their relocating employees.