Since credit scores have such a great impact on the success of a purchase or refinance it is essential to understand how they work. Today we will address how debt affects the Fico Score. Not all debt has an equal effect on credit scores.
There are different categories of credit:
3. Public records (court records)
Revolving credit includes overdraft on checking accounts, lines of credit, credit cards, and some home equity lines. Since revolving credit is the type that consumers have the most control over, the balances have a greater affect on credit scores. The higher the balances inch up to the aggregate limit the more the scores drops. Also, the individual balance to limit ratios of each account can affect the score negatively. If there is no limit listed on the credit report, automatically, the highest balance becomes the limit.
Here is an example:
Jim, who needed a bank loan for a mortgage, had to have a 740 plus credit score to get it. His credit score was 710, too low to qualify for the loan.
Jim had several credit cards:
-Amex: Balance is $12,000. Limit is $15,000.
-Capital One: Balance is $19,000. Limit is $22,000.
-Discover: Balance is $13,000. Limit is $15,000.
-Citibank: Balance is $450. No credit limit has been established. Jim never charges over $650.
-A second Amex: Balance is $1,000. Card must be paid off each month. Jim never charges over $1,500.
Overall, Jim’s balance to limit ratio on revolving credit is at 85% of his credit limit. This brought his credit score down 70 points. Paying the cards down to 7% of his credit limits could, after the new balances are updated on the report, get him above a 740 as needed for the better rate loan. To have the best scores, using the weight of balance to limit ratios on revolving credit, a consumer should keep balances no greater than 7% of the limits.
To show the difference in scores and how it affects the cost of a loan here is what Jim would be facing with a 710 Fico score vs. a 740 plus Fico score:
Jim was applying for a $600,000 Fannie Mae loan. At the 710 Fico score he would either have to pay almost $17,000 upfront in points (points are 1% of the loan amount) to get the lower 4% interest rate or if he didn’t have the funds to pay at closing he would have to settle for a 5% interest rate. At the higher interest rate he would be paying $1,159,540 over the life of his loan.
At the 740 plus Fico score he would be paying the lower interest rate and the total cost of the loan term would be $1,031,223.
His savings for 30 plus points on his Fico score would be $128,317.
It is a priority to educate buyers and clients who may be refinancing as to how much their balances impact credit scores. Consumers should pay down revolving credit 2-3 months before applying for a loan since it can take that long for the credit reporting agencies to reflect the change.
Feel free to call us with any questions or feedback 914-524-8300.
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