Credit scores can determine whether someone gets to enjoy the American dream or pay rent. These three little numbers can cause a conforming loan to become nonconforming. And while credit scores shoulder most of the weight in a credit decision, they are not cast in stone.
Inaccuracies in credit reports and scores, and the risks they represent for consumers are an ongoing challenge for the mortgage industry.
A study released last month by the U.S. Public Interest Research Group said that 25% of credit reports "contained errors serious enough to result in the denial of credit," and that 79% contained mistakes of some kind. These findings almost resemble those by David McGovern, who claims he has rescored over 1000 credit files, and who collaborated in a study that reportedly showed that about 70% of credit files contain errors -- 29% serious enough to derail a credit decision.
One study released in 2002 -- Credit Score Accuracy and Implications for Consumers -- reportedly found that out of the 200 million Americans that had credit files, an estimated 20%, or 40 million, of these had inaccuracies that could negatively impact a credit score and misclassify a consumer into the subprime category, instead of prime.
The study noted that if errors push a borrower's credit score below 620, the consumer usually ends up qualifying for a subprime rate. If, for example, this rate was 9.84%, on a 30-year, $150,000 loan, the borrower would end up paying $127,067 more in interest than if a prime rate of 6.56% would have applied with a score of 620 or above.
The National Association of Mortgage Brokers describes a credit score as a number from 300 to 850, that is based on an analysis of information contained in a credit report that provides lenders an indication of how likely a person is to repay his or her debts. The amount of debt owed and payment history including mortgages, credit cards, auto loans and bankruptcy fillings, as well as how long credit has been established and types of credit used, are all factors that help determine a credit score.
The three national credit-reporting agencies -- Equifax, Experian and TransUnion -- each independently collect data from creditors, public records agencies and other sources of financial information to generate and provide a credit bureau score to lenders. The three agencies use software developed by Fair Isaac and Company to formulate a credit score, widely known as FICO, which is used by virtually every lender to determine a borrower's level of future credit risk, according to myFICO.com.
While the studied percentage of inaccuracies can vary, what is consistently highlighted is that people's credit scores do run the risk of having errors and that credit scores have increasingly become a determinant factor in lending decisions -- according to creditrescoring.com, 85% of all lending decisions factor in a credit score to determine what interest rate a consumer will be charged.
But there are many things that a consumer can do or avoid to improve credit scores before purchasing the home of their dreams to ensure they get the rate they deserve.
NAMB recommends that consumers obtain a credit report from the three national credit reporting agencies to review for accuracy at least three months before applying for a mortgage. There is generally a fee, unless the consumer has been declined for credit due to information listed on their credit report.
Inaccuracies and outdated information in the credit file can be modified by the specific national repository by sending in a written dispute requesting the item to be reinvestigated and verified as to its accuracy. Consumers must also send in documentation to support the dispute and also request a return receipt from the repository. The process to make the necessary modifications will take approximately 30 days.
One thing prospective buyers can do to improve their scores is to pay down and keep all credit card balances below 30% of the credit limit. Having a low balance on several accounts is better than having a high balance on one or two cards, and therefore consumers should avoid closing out accounts to consolidate credit card accounts. Doing so will noticeably distort the appearance of credit utilization and if the balances lumped onto one or two cards are higher than the limits, they can indicate higher credit risk.
Apart from keeping credit card accounts open, prospective homebuyers should also keep them active by using them at least once every 5 months, NAMB said. Paying the bill in full will also help.
Because the number of inquiries during the last 12 months may affect a credit score, these should be kept at a minimum, NAMB advised.
Late or collection accounts should also be avoided. Making a payment or satisfying a collection account balance will not eliminate it from appearing in a credit file. While it will show a zero balance, it will disappear from the file until seven years after the occurrence, NAMB said.
While improving a credit file may take some work, Fair Isaac announced it has now extended its standard-setting FICO score to cover an expanded population base. The FICO score can now tap in nontraditional sources of consumer data to help lenders and other businesses assess the credit risk of adults who have minimal or no credit history on file such as recent immigrants, people with low incomes, recent widows and divorcees, and young adults.
Fair Isaac estimates 50 million Americans do not have documented credit histories adequate for calculating classic FICO credit scores, compared to an estimated 160 million that do.
The diverse network of information sources for nontraditional credit data Fair Isaac has developed to enable it to design and calculate highly predictive credit risk scores for overlooked consumers includes payment performance data on financial activities such as deposit accounts, pay day loans, and product purchase payment plans. Such information was previously not consistently maintained or accessible for commercial risk scoring.
"This extension of the FICO score gives lenders and other businesses another powerful tool for building and growing their presence in high-demand and emerging markets, while expanding service options for consumers who have missed out on opportunities simply because they lack a traditional credit history," Fair Isaac CEO Tom Grudnowski said in the announcement.