Credit Score

Several things come into play when it comes to determining mortgage interest. But credit scores, although among the most important, are also among the least understood. What is a credit score, how is it determined, and how does it affect your interest rates?

What It Is

Your credit score is basically a number that tells the lender how well you can handle credit. The report shows your past and present debt, payment histories, income, employment, and other financial factors. The higher your score is, the less likely you are to default on the loan-and since you pose a lower risk to the lender, they give you a lower interest rate.

How It's Calculated

The Fair Isaac Corporation (FICO) has devised the most widely used system for determining interest rates. The FICO score, which ranges from 300 to 850, currently follows the formula below:

Payment history – 35%. If you've always been on time with your bills, lenders know that you're likely to stay on track with your mortgage as well. Likewise, if you have a few missed or late payments, your credit score dips and your risk rises accordingly.

Total debt – 30%. How much money do you currently owe your creditors? This includes all other forms of credit such as credit cards, car loans, and credit lines. Having a large debt doesn't necessarily mean a higher risk; a person who owes $20,000 but has a good payment record will still score higher than one who struggles to pay a $4,000 debt.

Length of credit history – 15%. Borrowers who have handled credit for a longer time tend to score higher than newbies, provided they have a good track record. Although a shorter report makes less room for error, lenders can automatically consider you high-risk if you've just gotten your first credit card or never taken out a loan before.

Recent credit – 10%. Lenders consider it suspicious when you take out a lot of credit in a short amount of time. They might think you're trying to build a better record prior to taking out a mortgage, or that you simply make rash financial decisions.

Variety of credit – 10%. What types of credit make up your total debt? Does your student loan still take up most of it, or have you acquired credit cards and car loans since then? Borrowers with a healthy balance of credit types usually score better than those who stick to one kind.

Raising Your Score

To get the best mortgage rates, you want a credit score of 760 and above. Here are some quick tips to help you maximize your score before taking out a mortgage.

• Avoid quick fixes. A good credit score is built up over the years. The FICO system is designed so that short-term tricks, such as taking out new credit, may bring down your score instead of pulling it up.
• Know your DTI. Your debt-to-income ratio (DTI) determines how much of your current income will be taken up by your mortgage and other debt. Before applying for a mortgage, try to pay off as much of your debt as possible to keep the DTI at a comfortable level (usually below 31%).
• Don't encourage inquiries. Your score goes down a few points every time someone pulls up your credit score. To limit the inquiries, don't leave your credit information with an agency unless you're seriously considering doing business with them.