Improve your "credit score"— and pay less for a loan

The interest you pay depends on ratings that lenders have long kept secret. Finally, you can get your hands on your own numbers—and perhaps apply some polish.

By Susan Harrington Preston
Senior Editor

One lender likens today's controversial credit industry practices to a scene in the movie Cool Hand Luke. In the film, a prison guard knocks inmate Paul Newman to the ground. "What we've got here," the guard announces, "is failure to communicate."

If the lending industry is the guard and consumers the prisoners, the comparison is apt—except that most borrowers don't even know they've been hit. "Creditors aren't using credit reports anymore," says Ron Kingston, a lobbyist for the California Association of Realtors. "They use credit scores. And credit scores are not subject to consumers' right to review or correct or seek civil remedies."

In the past 10 years, credit scores have become statistical scalpels that separate borrowers into ever-finer groups according to default risk. Then lenders offer prospective borrowers loans with still finer gradations of costs. Even if you're a "prime" borrower, you could pay a higher interest rate than someone else who's a little more prime than you are. And credit scores get factored into virtually all of today's mortgage evaluations, not to mention lenders' decisions on car loans, credit cards, and other forms of consumer borrowing.

Until this year, you often couldn't even find out where you weighed in on the creditworthiness scale. Vigorous protests by consumers have changed that, though: Equifax, one of the three major credit bureaus, now offers scores and credit reports together for $12.95 online (www.equifax.com ), and the other two credit bureaus are about to follow suit. Experian says it will make scores available for $6 each by July 1, and Trans Union aims to provide scores along with credit reports by the end of the year.

The scores rate borrowers by credit history, usually on a scale of 300 to 850. However, all three credit bureaus, as well as many individual lenders and industries, use customized versions of the standard scoring formula, so their scales can vary a bit. You'll probably get a different score from each credit bureau. Mortgage lenders will use the middle score, not an average, and they'll combine it with other data, including the appraised value of the property and information from your loan application.

Most consumers score in the mid-600s to mid-700s, according to Fair, Isaac and Co., the San Rafael, CA, credit technology firm that developed the first risk-scoring formulas. (Because the firm dominates the industry, scores are often called FICO scores.) "In very broad strokes, the best interest rates are available to those with a score above 660," says Keith Gumbinger of HSH Associates, a Butler, NJ, firm that tracks mortgage rates. "But it ain't necessarily so." At the other end of the scale, credit scores below 620 are usually considered "subprime." Borrowers in this category can expect to pay higher rates for loans.

Even if a less-than-perfect FICO score boosts your interest rate by a small amount, the difference can add up to big money over time. A 7.75 percent rate on a $270,000, 30-year mortgage will cost you $92 more a month than a rate of 7.25 percent—$33,120 in extra interest over the course of the loan. Factor in what you could earn if you were to invest that money instead of paying it to the lender, and the difference really becomes startling.

Do you really want to hand your bank $33,120 more than necessary? We didn't think so. So if you're in the market for any kind of credit, pay attention: We're about to tell you how the scores are calculated—and how you might be able to boost yours. Making the right moves could save you a substantial amount, particularly if you're considering a mortgage or other large loan.

How credit scores are calculated

FICO formulas don't always work in a doctor's favor, especially if the doctor is young. The key factors, followed by the weight they're typically given, are these:

• Promptness of payment, 35 percent. Paying bills on time doesn't guarantee you a perfect credit score.

• Amount of existing debt, 30 percent. That's all debt, including student loans. The ratio of the debt you currently have to the total you could have also matters. The formula considers the top limits on all your credit cards and other flexible arrangements, such as home equity lines of credit.

• Age of credit accounts, 15 percent. If you open and close credit accounts frequently, you'll have a lower score.

• New debt, 10 percent. If you're establishing new credit accounts right and left and spending yourself into debt—as young doctors often do when delayed-gratification backlash kicks in—you get a lower score.

• Credit types, 10 percent. Finance-company credit is a negative because, statistically, it indicates a higher-risk borrower.

You can see how a young doctor could be in less-than-ideal territory. Say you're $100,000 in debt for your schooling. Sure, it's a student loan, but the kind of debt is less important (10 percent of the score) than the total amount (30 percent).

Not that you can count on your credit score to make sense. "I had a customer who is a physician," said Yuksel Manalp, a car-dealership finance manager, at a Federal Trade Commission conference in 1999. "His wife is a physician. They make a lot of money. And they go back to 1983 in the credit bureaus. And I counted three late payments . . . and [he and his wife] still have 77 percent of their credit line . . . available. His score was 585."

The late payments, Manalp recalled, totaled $175. Yet the bank Manalp worked with said the physician should pay 50 percent down and 22 percent interest.

"Three late payments might lower somebody's score by 70 points or so, but there had to be some other things there for the score to be that low," counters Craig Watts, a spokesman for Fair, Isaac. "The formula always makes sense."

Such confusion over credit scores doesn't surprise those in the lending industry. In fact, they've long used the potential for misunderstanding to support why they believe consumers shouldn't have access to their own scores. Now that scores are available, though, consumers can try, at least, to judge their credit situation for themselves.

How to improve your credit score

You can raise your credit score if you know what you're doing. If you don't, you may actually drive it down.

For instance, having too many credit cards can lower your score. So you should improve your score if you close some credit card accounts, right? Not necessarily.

Suppose you transfer five high-rate credit card balances to a new card with a lower rate and then close the high-rate accounts. That sends the ratio of current debt to potential debt soaring, which suggests you're already in over your head and looking to live on credit.

So is it better to have more credit cards with lower balances? Fewer cards with higher ones? There's no clear answer. But if you do decide to close some credit card accounts, leave at least one of your oldest accounts open, advises Watts. "That helps by giving you a longer credit history," he says.

Another problem is that the data card issuers supply to credit bureaus aren't standardized. Some issuers don't reveal your limit; others don't divulge your balances. So dumping certain cards may not have the desired effect on your score.

There are, however, a few sure ways to better your score if you have some time before you apply for a loan. The most important step is to check your credit reports for mistakes. You're likely to find some. "Out of every 10 credit reports I pull, seven are incorrect," said one lender at the 1999 FTC conference.

Be persistent about requesting changes, and make sure the changes are accurate. Both creditors and credit bureaus are notoriously slow to correct their records, and notoriously prone to making even more mistakes when they do. Setting the record straight can take many months—but it's worth the effort.

You can also improve your score by paying down your debt, especially credit card debt, and by paying promptly, especially if you haven't always done so.

Another important point: When you're shopping for a loan, don't let lenders pull your credit report every time you inquire about rates. Credit inquiries are reflected in your FICO score. Looking around for loans suggests you're short on money, so the more requests, the worse your score. Once you settle on a few potential lenders, request loan quotes from all of them on the same day. FICO formulas count all inquiries made within a 14-day period as a single request.

How to get a cheaper mortgage now

Rates have dropped this year, making loans more affordable. Here are ways to make sure you're getting the best mortgage deal possible for the credit scores you've got.

Shop around. While you're still house hunting, check around for lenders you might like to do business with. "Call as many as you have time to contact—no fewer than a dozen," says Keith Gumbinger of HSH Associates.

You can check average rates in most newspapers and on Web sites, such as HSH Associates', www.hsh.com/today.html . But rates may vary for no apparent reason. "Two companies in the same town may be offering completely different rates," says Neill Fendly, president of the National Association of Mortgage Brokers in McLean, VA. "It's no different from buying furniture."

Get preliminary quotes without credit reports. Timing loan inquiries can be particularly important with mortgages. Mortgage preapprovals and rate lock-ins that require credit reports can backfire if you request them too early. When you finally apply for the loan, you may need to go through the approval process all over again, and your credit scores may slide and raise your final costs.

"You usually can't apply for the loan until you have the property, anyway," notes Gumbinger. The exception, he says, are "lock-and-shop" programs; for those, you apply first thing. "But you must do all your mortgage shopping beforehand," he warns.

Until you're ready to get the loan, stick with prequalification. For this, lenders simply supply basic rate information and estimate how big a loan you're likely to qualify for, based on the most accurate information you can provide.

Compare terms. The more certain you are about the kind of loan you want, the easier it is to compare loan offers. Decide whether you want a fixed-rate, adjustable-rate, or hybrid loan; the size of your down payment; and whether you're willing to pay "points" up front to lower your interest rate. Also ask lenders for a list of their closing costs; some lenders tack on more fees than others. To help you compare mortgage offers, you may want to complete the worksheet available at www.ftc.gov/bcp/conline/pubs/homes/bestmorg.htm. It's especially useful if you're still equivocal about the loans' terms.

Go to the right places. Lenders that cater to subprime borrowers needn't offer the best rates, so you're better off borrowing elsewhere, if you can. Subprime lenders aren't obligated to tell you that, however, and spotting them isn't always easy. Banks often have subprime lending subsidiaries, and finance companies may not advertise that they offer high-rate loans.

The subprime industry group, the National Home Equity Mortgage Association, lists members in a searchable database at www.nhema.org. Before applying for a loan, you may want to make sure the lender of your choice isn't included.

If you're an established customer at a local bank or savings and loan, you may get consideration that you wouldn't get elsewhere. This is especially helpful if you're borrowing more than $275,000. These "jumbo" mortgages typically cost one-quarter or three-eighths of a point more in interest, because they're too big for a lender to resell to Fannie Mae or Freddie Mac. If the bank decides to fund your loan itself, you could get a break. A local bank can also be helpful if your credit score seems wacko for no good reason.

Finally, check brokerages and your credit union, if you're a member of one. Neither is a traditional source of mortgages, but both may offer them.

Get all your final quotes at once. Controlling the timing of credit inquiries isn't the only reason to request final quotes from lenders on the same day. This Wednesday's quote from bank B may be a little better than last Friday's quote from bank A, but bank A's deal may have changed since then. "You're not comparing apples with apples if they're not on the same day," says Fendly.

 

Sue Preston. Improve your "credit score"--and pay less for a loan. Medical Economics 2001;10:46.