I was asked recently who has the best mortgage for people with “low credit scores.”
“Low credit score” is a nebulous term, so let’s see if we can narrow it down a bit.
A borrower’s FICO score is a three-digit number derived from data kept in each of the three credit repositories: Experian, Equifax and TransUnion. The FICO models (there are several of them) consider payment history, credit utilization, age of accounts and types of credit, among other factors. “Derogatory” entries include a history of late payments, collection accounts, over-limit credit cards and public record entries such as foreclosures, bankruptcies, liens and judgments.
Conventional loans (those that will ultimately be purchased by Fannie Mae or Freddie Mac) require a minimum score of 620. FHA loans, which are insured by the Department of Housing and Urban Development, will allow scores as low as 580 with a 3.5% down payment.
To have a score as low as 580 or 620, a consumer must have some combination of the following negative factors:
- Recent history of late payments
- Unpaid collection accounts
- Public record items
- High credit card balances
Each of these factors lowers a consumer’s credit score. Some of them, assuming they have been correctly reported, can’t be fixed quickly. Others, however, lend themselves to immediate remedy—and significant score improvement.
A word about “credit repair.” There are companies that promise to improve a consumer’s FICO score—for a fee. They claim that they can remove even those derogatory entries that are correct. They do this by disputing every negative item on the consumer’s credit report. Under the Fair Credit Reporting Act (FCRA), credit bureaus are required to investigate these disputes with the creditors and confirm their accuracy within 30 days. If they are unable to confirm them, they must delete them.
The credit repair company knows that some of the creditors reporting negative information will not respond to the credit bureau’s query within 30 days. In that case, the negative entry will magically disappear from the consumer’s credit report.
The problem with this is that while the derogatory entry may disappear, the creditor may report the same negative information to the credit bureaus at a later time. Furthermore, while the account is “in dispute,” it will be reported as such on the consumer’s credit report. Lenders know how credit repair companies operate, so they require that disputes be resolved. Removing a dispute (but not the negative entry) will cause the consumer’s score to go down.
Apart from trying to remove accurately reported negative items from one’s credit report through a sort of loophole in the law, there are some actions a low-FICO consumer can take to get an immediate—and often dramatic—improvement.
If a consumer doesn’t make their payments on time (or doesn’t make payments at all), the creditor will assign the account to an internal department or third party to collect the debt. When they report the account as being in collection, the consumer’s credit score takes a beating. Not only is there a history of late payments, but the balance reported may be over the credit limit, with a past-due balance. A single account could cost 50 points on a consumer’s FICO score.
The first step is to contact the creditor or collection company to negotiate a settlement. I know, I know…these people are nasty and rude. They’ve been dunning you mercilessly for payment. They are threatening to sue you.
You have to talk to them. Be aware that bill collectors are really sales people. It’s the dark side of sales, but they earn a commission based on the money they collect. In most cases, they are willing to settle for a lesser amount than what they have reported to the credit bureaus. In many cases, the collection company has purchased the debt for pennies on the dollar, so everything they are able to collect over what they paid is profit to them.
When you speak with a collection agent, tell them you’d like to settle your account. They’ll give you a number, which will include accrued interest and late fees. Tell them you can’t pay that, but you’d like to offer this much for full settlement of the account. The bill collector will tell you they have to “talk to the manager.” They’ll put you on hold for a few minutes. When they come back on the line, they’ll either give you a higher number, or accept he offer you’ve made—but only if you agree to a “check by phone” right then.
Don’t do it.
You should not agree to give them any money without having a settlement from them in writing. The agreement—which can be in the form of an email or fax—should specify that they will accept the proposed amount in full settlement of the account. They should also agree to immediately report the account as settled. This won’t change the history of past-due payments, but the status will change from “collection account” to “paid collection. This will improve your score significantly.
Credit card balances
The FICO model refers to “credit utilization.” This means the balance on credit cards as a percentage of your credit limit. When you exceed about 30% of the credit limit, your score starts to suffer. A maxed-out card can cost you 20 points on your score. If you are over the limit, the impact could be 30 points.
Paying down credit card balances helps you in two ways. First, keeping your balance below 30% will improve your FICO score. Second, do you really want to keep paying 18% or more on those balances? It is a waste of your money.
Public record items
If someone sued you in small claims court and won, the court will enter a judgment against you. Your credit report will how the amount of the judgment, and possibly a lien, depending on the type of action. You’re going to have to settle it one way or another. After you settle, the judgment will still appear on your credit report, but the effect will not be as severe. Most lenders will require that judgments be satisfied before they will approve your loan.
The power of time
A low credit score is never permanent. The older a negative item gets, the less its effect on your credit score. A missed payment to Macy’s last month could cost you 25 points. A year from now, the cost could be just 10 points (assuming no other derogs). After two years, the effect is negligible.
Are there lenders who fund “sub-prime” loans for borrowers with very low credit scores? Yes. But they invariably charge very high rates and require larger down payments. It is a far better strategy in every respect to perform some rudimentary cleaning of your credit picture in ways that will genuinely improve your financial situation. If you have the funds available to deal with these items, you could be 30 days away from a much higher credit score—and far better terms or your financing.
Mortgage lenders use the borrower’s credit score to determine the rate they will get. Fannie Mae and Freddie Mac call this “risk-based pricing.” They publish a chart containing ranges of credit scores and loan-to-value ratios. Where the two axes intersect for a given borrower, the lender will find the adjustments to the interest rate. A borrower with a 620 score will pay about .75% more in rate for a conventional loan than will a buyer with a 740 score. The adjustments for FHA loans are equivalent, except that FHA allows a score as low as 580 for a loan with a 3.5% down payment.
We are always happy to provide advice and guidance for getting the best loan possible–even if your credit report shows some battle scars. You can always call us at 925-383-2846.