Josh Robles: Observations on Credit Scores

Credit Scores

by Josh Robles

Working in lending for the last 10 years, I’ve been privy to some of the standard practices for underwriting and extending credit, both in the consumer and commercial markets. The single most popular aspect of credit most people are aware of is the credit score. Even seasoned professionals can’t easily explain how the score is determined, and most people assume a big number means you have good credit. Well… that isn’t always the case.

In reality, the credit score is a misleading number. It is promoted by credit reporting bureaus (i.e. TransUnion, Equifax and Experian) as being the best way to track your credit. Actually, it is rarely used with such regard by financial institutions, and by itself tells little about an individual’s credit. If most loan officers (by most I mean all) can’t tell you how it’s calculated, how can they use it as an effective tool for managing risk? It is very possible to have a good or even great score but be denied for a loan. While a low score can mean an auto-denial, a high score doesn’t ensure approval for a particular request.

People fail to realize that lenders must take into account the type(s) of credit maintained in addition to how well they’re maintained. One can have a great score, based only on credit cards, and be quickly denied for buying a house or nice car. Few lenders will risk you paying a $2,000 mortgage or $500 auto note, when you’ve only had prior experience managing two credit cards with max limits of $1,000 and a max monthly payment of $100, even with the income to support the request.

Credit is extended based on a number of factors, namely your income and creditworthiness. Creditworthiness is a term used to describe your ability to manage and obtain credit, and is determined by your credit history and credit score. Creditors often place as much, if not more emphasis on your credit history than your score. When I say credit history, I am referring to the specific credit lines (we call them trade lines in lending jargon) that you have acquired and maintained over the years. If you ever pull a credit report (and you absolutely should) you will notice that all your previous credit obligations are described in a section that details the type of credit, amount of credit and your payment history (as well as numerous other aspects of that particular obligation). These are the details that creditors and lenders pay the most attention to, not simply the score at the top.  Creditors want to know that you have the experience managing financial obligations similar to what you intend to borrow. If you want to buy a $500,000 home, you better have more than an American Express or Visa card, even if your score is 810 or above.

There are three main types of credit transactions: revolving, installment and mortgage/real estate. Revolving credit transactions refer to credit accounts which can be advanced, repaid, then advanced again. Credit Cards typically fall into this category, as well as other types of loans which can be borrowed and repaid in that fashion. Installment accounts refer to loans which are originated for a specific dollar amount, then repaid on a specific schedule until they payoff or mature. Car loans typically fall into this category, as you generally borrow a set amount and then repay that amount over a set period of months, until the debt is satisfied or the loan matures. Real estate or mortgage accounts are typically installment loans that have some type of real estate as collateral. I say typically because there are some revolving types of mortgage loans (i.e. Home Equity Line of Credit). These types of loans are usually for high-dollar amounts that take many years to repay.

In general, mortgage credit is considered the gold standard for credit purposes; because of the large size and repayment term they offer potential lenders a good track record on your ability to repay large debts over long periods of time. Installment loans come in second, and revolving loans follow in a distant third. The reason revolving loans don’t rate as high as installment or mortgage is because you have no set obligations to live up to. I’m sure you’ve heard plenty of people recommend obtaining a credit card and not using it at all, in order to build credit. Well guess what, lenders can see your average revolving balance and know that you can have a credit card and never use it. This doesn’t really give them a sense of how well you manage to repay large sums of money on a recurring basis. Thus, revolving lines are not as highly regarded when compared to installment and mortgage credit transactions, especially when you are trying to obtain a large dollar loan. That’s why credit cards are good at starting credit, but not so great for building credit.

This brings me to my final point; one of the most important aspects of credit is not your credit score, but your credit age. The longer you’ve been repaying obligations, (assuming you make all payments on time of course) the better your credit will look to potential lenders.  Credit scores do not weigh credit age as highly as other factors, however lenders do. As mentioned above, having an old mortgage account far outweighs an equally old credit card.

Hopefully this give a little insight for those interested in credit and where lenders focus.  Also remember, credit reporting bureaus are required to issue a free credit report once a year, I highly recommend everyone take advantage of this right. You can access this through the FTC’s website:http://www.ftc.gov/bcp/menus/consumer/credit.shtm. You should know what is on your credit, be it positive or negative. After all, how can you make it better if you don’t know what’s there??

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