Understanding Credit Scores


Karen Behfar

For all the new buyers that just started looking to make the move, I’ve decided to take this opportunity to go back to the basics and give you the run-down on credit scores.  This is definitely a good starting point, but of course it is not the only step involved in beginning the  process of purchasing a home.

The Basics of Credit Scores

If you’ve ever heard someone referring to their credit score and thought, “Huh?”, you’re not alone. Roughly forty percent of Americans don’t know how credit scores work. Here are the basics:

A credit score helps lenders – like banks and credit unions – decide whether you qualify for a loan, and it helps to determine the terms of the loan they can offer you. It is generated using an algorithm that examines your borrowing history, which is calculated by checking your credit reports. Every time you take out a loan, your lender reports the activity to a credit bureau, which then compiles it into a credit report.

Although there are multiple types of credit scores, the most popular score is the FICO score, which is the standard for home and car loans. Your FICO score will range from 300 to 850, incorporating the following components:

  • Payment history, including missed payments and defaulted on loans (35%)
  • Current debt, including how much you presently owe (30%)
  • Length of credit, including your full borrowing history (15%)
  • New credit, including any loans you’ve applied for recently (10%)
  • Types of credit, including all your existing types of debt (10%)

Since your payment history and current debt make up more than sixty percent of your score, they are the two most important elements. The best way to do well in these areas is to make all of your payments on time, and ensure that most of your available credit is unused.

As a rule of thumb, credit scores considered “good” typically fall between 670 and 740. Anything above 800 is considered to be exceptional, and anything below 580 is considered to be poor.

An annual free credit report is available to all U.S. consumers under federal law, and many banks provide free credit scores. It’s important to check your credit score regularly, so if you’re unsure about what your credit score is, make an appointment to discuss it with someone at your financial institution.

Home Equity Line of Credit

Let’s talk about another very important part of the home buying process – loans.  More specifically, a HELOC (Home Equity Line of Credit).  To break it down in short, if a homeowner bought their house a few years ago for $400,000 and it’s currently worth $1.2M – this is the equity in their home.  Obviously, it goes against your home and there is a monthly payment.

The Basics of HELOC Loans

 If you’re thinking about taking out a loan for something major – you might want to consider a home equity line of credit. With a HELOC you can use the equity from your house as collateral, similar to a second mortgage.

Unlike a traditional home equity loan, with a HELOC you won’t be advanced the entire loan upfront; instead, you’ll be given a line of credit to borrow against with a set credit limit. Your HELOC will also have a set “draw period” during which you can borrow funds. You will be required to repay the amount you’ve withdrawn, plus interest, by the end of your draw period.

One of the main benefits of a HELOC loan is that the interest paid can often be deducted under state income tax laws. However, it’s important to remember that the interest rate on a HELOC is typically variable and is based on an index, so it may change over time.

A HELOC also offers more flexibility than a traditional home equity loan because it allows you to repay on your own schedule. You can pay back your loan using the minimum repayment amount over the course of your entire draw period, or you can repay the entire sum plus interest in a single payment if you prefer.

If you’d like to change the rate, payment, or term on your HELOC, it is possible to refinance. You may be able to replace your existing HELOC with a new one, or merge your HELOC with a first mortgage to take advantage of lower interest rates. You can also take out a second HELOC, which will reset your interest-only draw period and keep your monthly payments low. This can be a slippery slope though, so it’s best to consult with your financial advisor first.