Higher Rock Education - Economics Blog

Wednesday, June 28, 2017

How a Lender Reads Your Credit Report

Your friend, George, approaches you for a $5,000 loan. George is willing to pay you 4% interest, while your bank is only paying 1% on certificates of deposit. Would you lend George $5,000? You would probably ask several questions related to George's character when making your decision. Will George pay me back? Is George honest? Bankers ask the same questions when underwriting a loan. An applicant's credit report is used frequently by banks, employers, landlords, and other institutions to review a person's character.

Character – Credit

A credit report provides a banker with the relevant information regarding an applicant's credit history and payment obligations. In the United States, there are three primary reporting bureaus: Equifax, Experian, and TransUnion. Lenders furnish information to the credit bureaus, who consolidate the information to create a report. A credit report contains some personal information such as a social security number, present and past addresses, but most of a report is related to an individual's credit history. Let's assume George applies for a loan. Information provided related to his loans include:

  • Who has George borrowed from?
  • What are the terms of George's loans (payments and credit limits)?
  • How many times has George been 30 days, 60 days, and 90 days past due on his payments? When was he past due?
  • Did George ever declare bankruptcy or has there been any other recent legal action against him?
  • Has George applied for any loans or had credit pulled by any other companies within the last two years?
Credit reports reveal a person's character. Timely payments are indicative of people who are honest and responsible. Untimely payments may indicate the applicant is not very conscientious or in financial trouble. In either case, a banker would not want to make the individual the loan. Only borrowers with outstanding credit should expect to secure the lowest rates. It is very expensive for lenders to constantly chase borrowers for their payments, so naturally if a banker believes there is a good chance he will have to work hard to be paid, he will either decline the loan or charge a higher rate.

Bankers are not the only people who use credit reports. Approximately half of employers pulled credit for a job applicant according to a study by the Society for Human Resource Management in July 2012. Reasons given are to reduce theft and protect themselves from litigation. Landlords use credit reports when considering a new tenant. Business owners may be turned down by their suppliers if they have poor credit.

Credit Score and Automated Underwriting

Credit scores are supposed to objectively weigh a borrower's credit risk at a given point in time. They have been used for decades, but scoring has gained importance following the use of automated underwriting. Automated underwriting allows lenders to quickly reach a lending decision by plugging in data that has been verified. My company used automated underwriting to approve mortgages within minutes. Lending decisions are more objective.

Bad things happen to good people. Perhaps credit problems resulted from a serious illness or the loss of a job. In the past, it was easier for underwriters to dismiss credit issues if the applicant could provide an understandable explanation. Bankers also may have issued a loan because they knew the family and a family member would make a payment if another member defaulted. Today, a loan officer will rarely approve a loan that has been denied by automated underwriting because they would have to endure added scrutiny if the borrower defaults. This is especially true since more loans are sold in the secondary markets. On the plus side - it is much more difficult to discriminate because automated underwriting makes it more difficult for a loan officer to refute a loan that is approved by automated underwriting.

The Scoring Model

The Fair Isaac Corporation developed the most used scoring model. A person's "FICO" score can range from 300 to 850, where higher scores are better. VantageScore is another popular model. FICO's factors and their weights are listed on Table 1 below.

The table below lists the factors and their weight in calculating the FICO Score.

Payment History35%
Amount Owed30%
Length of Credit History15%
Credit Mix10%
New Credit and Inquiries10%

Source: My FICO

Payment History:

Understandably your payment history is very important when determining your credit score. Payment history is given the highest weight of 35%. Your payment history is probably a good indication of your future behavior. Many families with credit challenges who applied for a mortgage with me believed that they could pay off their delinquent accounts and their credit would be perfect. This is not true, and there is not a quick cure. One 30 day late payment can drop a person's credit score between 60 and 100 points (Equifax). Paying off delinquent accounts would have an immediate positive impact on a person's credit score, but the adverse effects of past delinquencies would remain. Recent history is weighed more than past history, and payments that are 90 days past due hurt a credit score more than payments that are 30s day past due. The negative effect of a late payment will decrease over time, so scores will gradually increase if a good history is maintained. Late payments should disappear from your report after seven years. 

Amount Owed: 

If you are at your credit limit or "maxed out" on many of your credit cards, it may indicate you are in financial trouble. People who are consistently at their credit limit are usually living beyond their means. For this reason, the relationship between your outstanding balance and your line of credit or credit utilization ratio determines 30% of your credit score. Your credit utilization ratio equals the amount owed divided by your credit limit. Note that the amount owed is normally the balance on your last bill. Credit card companies only report balances to reporting agencies once a month so payments made since the balance was last reported are not reflected on the account. Generally limiting the balance to 30% of the line of credit is recommended. The higher the ratio, the more it will adversely impact your credit score.

I am hurt the most by this category. I do not like debt, so I have a relatively low line of credit on my credit card. I have one card, which I use for most of my purchases. I pay it off every month to avoid interest and minimize fees. Sometimes I owe over 50% of the line of credit when I receive my bill – which is the balance reported to the credit bureaus that is used to calculate my FICO score. The bottom line is you need to maintain a low balance on your credit report if you want to maximize your credit score. I could remedy this by either having my credit limit raised or opening and using new credit cards. Each action would reduce my debt utilization ratio – but given my adversity to debt and my relatively high credit score, I prefer to use only one card with a lower limit.

Many people believe credit utilization only applies to credit cards. This is not true. The credit utilization rating applies to installment loans as well. Your credit score would go down if you purchase a car using a car loan, even if you make your car payments on time. Your credit utilization rate would increase. Paying down the principle balance on your car loan would boost your credit score by lowering your credit utilization.

Length of Credit History: 

A long track record of making timely payments says a lot about a person's character. FICO recognizes this, so a longer good payment history is rewarded in its scoring model. When writing mortgages, I called this the "penalty for being young". Young people who are establishing themselves are penalized because they recently opened a couple of lines of credit. This is especially true if the borrower is just starting a new job. I saw few young people with scores exceeding 800 when I originated mortgages. 

Think twice before closing a credit card if it is your oldest card and you have been responsible in making payments. Closing this account would reduce your length of credit history. Some of my customers frequently jumped from one credit card company to another with a lower rate or better deal. They normally had great payment histories and expected very high credit scores but were hurt by this factor as well as the number of recent inquiries, which is discussed below.

Credit Mix: 

Loans are generally two types: revolving and installment. Revolving accounts include credit cards, a retail charge card, and many home equity lines of credit. Revolving accounts specify a credit limit and borrowers can draw against the line of credit, pay it down and then draw on it again. For example, you may have a credit card with a $500 limit. Assume in the first month you borrow $400 and then pay it off. The next month you borrow $300 and pay $200. You borrow $200 in the third month. You have borrowed a total of $900, which is far more than your credit limit, but because you pay down the balance you have never exceeded your $500 line of credit.

An installment loan is usually for a specific purpose, such as buying a car. The bank lends you the full amount and you normally have monthly payments. Once the loan is paid down, you are not allowed to draw on it again. Examples include car loans, student loans, and mortgages. For example, assume that you owe $10,000 on a car loan, and your payment is $400 per month. When you make a payment, $75 is interest and $325 is applied to the loan balance. Your new balance equals $9,675. You are not permitted to draw on this loan back to $10,000.

I confess I do not understand why having a mixture of credit types makes a person any less of a risk than having only one type of account. This FICO site implies that people with experience paying different credit types have more experience and discipline so they are less of a risk. The site also recommends not opening a different type of account to increase your credit score. Credit mix accounts for only 10 percent of your score and opening another account would decrease your length of history, add an inquiry, and increase your credit utilization, all of which lower your credit score.

New Credit and Inquiries:

A lender is making an inquiry when he pulls your credit report. In most cases if new credit is extended or a person is applying for a lot of credit, something is happening in the person's life that increases the chances of default on a debt. New debt means more debt obligations, which means that there is a greater chance of default, assuming the borrower's income is unchanged. The exception is when multiple credit inquiries are made when shopping for a car on mortgage. In these cases, only one inquiry will be counted because FICO recognizes that you will only be securing one new loan. It is also important to note that inquiries made that do not involve securing a loan, such as an employer pulling credit for a job applicant or periodically reviewing your own credit report, do not count against your credit score.

What Is a Good Credit Score?

So, what is a good credit score? Good is a relative term, and changes depending on the type of loan and lending environment. Generally, a score above 700 is considered a good score and qualifies a borrower for a very competitive rate. See the Experian pie chart. A lower score does not mean a borrower cannot secure a loan, but he or she may have to pay a higher interest rate.

A Credit Score Is Not a Reflection of a Person's Wealth

It is true that wealthier people probably have the means to pay off their debts. However, when I owned a mortgage company I saw little correlation between a person's credit score and net worth. Think about it - none of the factors listed relate to a person's net worth. If a person inherited several million dollars a month ago, her credit score would not have changed, assuming her behavior is unchanged. Likewise, a person's credit score would not increase following a jump in their salary.

What if I Find a Mistake on My Credit Report?

Frequent mistakes are made in reporting, so I advise reviewing your credit reports annually. The law requires the credit agencies to provide you with a free credit report once a year. A fee is normally charged for adding your credit score. Listed below are the web addresses of each of the credit bureaus. Visit Nerdwallet to learn more about receiving your free annual credit report.

The credit bureaus must research and change any errors on your account within 30 days of it being reported. In addition to reporting errors, I encourage you to furnish any supporting documentation you may have to verify your claim. A good step by step article for correcting errors is Credit Karma.

Should I Get Rid of All Credit Cards?

Some financial advisers recommend shredding all your credit cards and paying off all your debts. I respectfully disagree. I recommend paying off your credit cards every month and being responsible in making all of your payments. I also recommend only carrying one or two credit cards. However, if you have one card and are not disciplined enough to pay it off each month – SHRED IT – You may have a buying addiction that is fed by easy credit. No credit is better than minimal credit when a person is unable to handle credit responsibly.

The responsible use of credit cards has many benefits, and the added fees are minimal when payments are made on time. When I travel I do not like to carry a lot of cash. When traveling abroad, credit cards frequently provide better exchange rates than the local merchants or banks. Renting a car is more of a challenge without a credit card. They may also have the added benefit of insurance for the rental car. For example, our family rented a car and noticed a crack in the windshield several miles down the road. The credit card company covered the damage.

Having no credit will probably make it more difficult to secure a loan if you want to open a business or purchase a home. It seems illogical that someone with no credit would be a greater credit risk than a person with a good credit history. After all, if two people have the same income, the person with no credit is better able to afford the payment. We began this blog asking you to decide on whether or not to give George a loan. If you know George well and he is honest and hardworking and has no credit then I agree, lending to George carries less risk than lending to someone who has several loans. But the banker doesn't know George or most of the people who apply for loans. He doesn't know if they are honest. The best measure he has is past payment history, which is why he bases so much of his decision on the credit report.

For additional information read WalletHub's article, "What is a Good Credit Score". You can also use Wallet Hub to check out your credit rating. WalletHub offers free credit scores and full credit reports that are updated on a daily basis.

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