In order to understand credit, one first has to understand what is meant by good credit versus bad credit in the world of mortgage financing.
PAYMENT HISTORY: A historic review of how payments have been made in the past.
1) A borrower who has never had a late payment on their history is the profile of the ideal risk
2) A borrower that has had isolated late payments displays the ability to recover from possibly difficult situations by taking responsibility for their obligations and bringing them current and keeping them current for an extended period of time.
3) Borrowers who are consistently late in paying creditors reveal a general disregard for their payment responsibilities, and are considered a non-optimum credit risk.
OPEN ACCOUNTS: The ideal borrower will have several open accounts. The use of credit in the past will prove the borrower understands these obligations. The fact that other creditors have extended credit indicates the consumer has already met some type of lending standard.
TYPES OF ACCOUNTS:
Mortgages: Because of the large debt, a real estate mortgage is treated as the most serious financial obligation. A consumer who has had a mortgage in the past is the best risk because they have already displayed the ability to manage this huge financial responsibility. An individual who has only rented or lived with family members poses a much higher risk because the only consequence to not paying rent was finding a new residence.
Installment loans: Installment loans are weighted as the second most important financial obligation. Installment loans such as automobiles show the ability to make a fixed payment for a predetermined period of time.
Revolving Credit: Finally, the use of revolving credit such as credit cards is used in determining credit scoring. Since revolving credit allows the consumer to use up to the credit limit repeatedly, these debts have no end date. Because minimum payments are so low and the principle is usually not reduced by minimum payments, revolving credit is given the least weight in determining credit risk.
LENGTH OF CREDIT HISTORY: The length of credit history in very important in determining the credit score. A consumer who has used credit for many years paints a picture of what the future may hold. For example, the consumer who has used credit for 30 years most likely has experienced several economic recessions and therefore should have the ability to handle future economic difficulties.
The reverse of this example is the consumer who has had credit for only two years and may not have experienced economic turmoil. A short credit history cannot predict future performance accurately.
PUBLIC RECORDS: Public records include items such as liens, judgments, foreclosures and bankruptcies. These items are of great importance in credit scoring. Public records display the historical need for a creditors’ use of the court systems in an attempt to reclaim unpaid debts. The need for previous creditors to resort to legal action in order to be repaid represents high risk for the new creditors.
COLLECTIONS & CHARGE-OFFS: Items for which payments ceased to be made and were therefore turned over to a collection agency or written off as bad debts.
ACCOUNT BALANCES: The balance on accounts plays an important role in determining credit scores. Account balances on mortgage and installment loans show the time that has passed since opening the accounts. These balances also demonstrate whether the debt is being managed responsibly by showing the amount of time that has passed since a late payment has been made.
In the case of revolving credit accounts, the balances show how the consumer uses credit. The ideal balance on revolving debt is 30% of the available credit limit. The 30% figure is ideal because it creates history, which can be reported, yet it shows restraint on the part of the consumer.