Your credit or “FICO” score is critical to your real estate investment career. The simple fact is that the higher your credit score, the greater the chances of your obtaining loans and getting them at a lower interest rate. It keeps valuable money in your pocket!
Remember this primary fact: lenders are in the business of loaning money and loaning it at the lowest risk possible so they’re going to look long and hard at your credit score before pulling cash out of their own accounts. This information tells you that you should understand how credit scores are calculated and what you can do to raise your own credit score if it’s low. This article provides you with that fundamental information
A Brief History of Credit Scoring Credit ratings are arrived at by a formula used by lenders and others to give them an objective method to predict how likely it is that you will repay a new loan. A credit score is the result of complicated formulas for determining your credit worthiness.
You’ll often hear a credit score referred to as a “FICO” score. This term comes from two men named Fair and Isaac. In 1955, they founded a company called Fair Isaac Corporation. Over the years, the name got shortened to “FICO.” Fair, Isaac is a for-profit company, traded on the New York Stock Exchange (NYSE: FI). Their exact formula for calculating credit scores is proprietary; that is, it’s secret.
Each of the major American credit reporting agencies (CRAs) has a business relationship with Fair Isaac. The three major CRAs are: Experian, Equifax, and TransUnion.
Now, you’d think that each credit reporting agency would have the same score for each person, but they have different models for determining your credit score so your score may vary from one CRA to the other!
On the whole, they’re still referred to collectively as “FICO” scores. Each model is based on experience with millions of consumers. With each model, the higher your score, the better your credit rating.
Calculation of Credit Scores A credit score depends on the credit scoring model used by the CRAs. In general, FICO models analyze these items in your history: * Past delinquencies * Derogatory payment behavior * Current debt level * Length of credit history * Types of credit * Number of inquiries by lenders and others into credit history.
Although the models vary as I stated above, the general formula looks like this:
* 35 percent on a borrower’s payment history. * 30 percent on debt. * 15 percent on how long the applicant has had credit. * 10 percent on new credit * Another 10 percent on types of credit.
There is a range of FICO scores. Within that range, the higher the score, the better your credit rating is. For example, a perfect score is 850 (only 1% of the U.S. population). Eleven percent (11%) of the population has a score of 800. In the above two instances, the borrower likely will get a lower interest rate and have the loan closed within days.
The average individual has a FICO score of 720. The interest rate will be higher, and it’ll take days or weeks to close the loan.
In the event your FICO score is less than 600, it’s likely that you’re going to have trouble getting money from conventional lenders. That’s because they calculate you’ll default on that loan better than 50% of the time. Naturally, it doesn’t make good business sense to lend money in that situation. Or, if they do loan the money, it will be at a significantly higher interest rate in hopes of covering the risk. Lenders examine your records closely for “red flags” to decide whether or not to give loans to individuals with low credit scores. Red flags include: missed payments, late payments, unpaid debts, bankruptcies, etc.
Common-sense Guidelines for Raising Your Credit Score The first guideline is to pay your bills on time-all the time. The second guideline is to not open unneeded credit card accounts to increase available credit. That raises red flags for lenders. The third guideline is to budget to figure out where you’re currently at financially. The fourth guideline is to reduce unnecessary expenditures so you can apply that saved money to your debt and improve your credit score.
If you’re unsure about the state of your current financial situation, you can analyze it using the debt to income ratio formula. It’s a simple method of measuring your net monthly income against your debt.
Here’s an example: Assume your net monthly income is $2000, and your monthly debt payments are $500. Now, divide $500 by $2000, and you’ve calculated your debt to income ratio: 5002000 =.25 (25%).
It’s generally agreed that debt expenses should be 25% or less of your income. A ratio of 10% or less is great. Anything above 25% is a red flag for you and may be for lenders. If it’s 25% or more, you definitely need to reduce or eliminate debt!
To calculate your current debt to income ratio, take the following steps: * Look at last month’s bills and total up all the fixed expense items (rent, mortgage, car payments, child support, loan payments, etc.). * Then, check your credit card bills and add up the minimum payments owed on each card. * Figure out your monthly take-home pay (net salary). * Divide monthly fixed expenses by monthly income.
Key Point: A good credit score is vital for your real estate investment career! If it’s low, do everything you can to raise it.