The 411 on Fico Scores and your Ability to Purchase a Home

14 11 2011

Featured in America Saves’ National Campaign – November 2011

“Don’t let credit mistakes from your past ruin your financial future”

What is a FICO score?  Does it affect my ability to become a homeowner?  Should I worry if my score is low and how do I raise it?

The Facts

A credit score (a/k/a FICO score) is a leading indicator of whether one will be granted credit and at what interest rate.  FICO scores are produced via complex methods that indicate whether certain borrowers are creditworthy based on their ability to repay a loan.  The exact statistics used to calculate one’s score are secretive, however Fair Isaac and Company (FICO) published these five indicators:

  • Payment History 35%.  Payment history accounts for 35% of one’s credit score.  How often and how many bills are paid late?
  • Amounts Owed 30%.  How many accounts have balances?
  • Credit History Length 15%.  When was your first account opened?  Closing older accounts can have a negative effect on one’s score.
  • More Debt 10%.  Are you constantly opening new accounts?  Avoid the pitfalls of signing up for credit because of store-offered discounts.  Opening accounts for this reason may negatively affect your score.
  • Credit Types 10%.  Do you have a diversified credit history containing credit, personal and/or car loans, mortgage loans, etc.?

The Past

Many people have faced obstacles in their past – payed bills late, maxed out credit cards, spent more than they earned, etc.  Positive financial management starts with changing behavior and learning from one’s financial mistakes.  Pay bills on time, avoid charging more than 30% of the credit limit issued by the credit card company and continue to pay down debt.

The Present

Maintaining and monitoring your credit history is important.  A low FICO score will always suggest higher interest rates when applying for credit.

So, what is your score?  The FINRA Foundation makes FICO scores available free to active duty service members and their spouses.

After you have received your Fico score and credit report, always monitor your credit report for accuracy.  Any errors or discrepancies should be disputed with the credit reporting agencies (TransUnion, Experian and Equifax).

In addition to paying bills on time and limiting your amount of debt, service members should fully understand the importance of maintaining good credit.  If not practicing positive financial management, service members could potentially risk a Security Clearance revocation.

So, what actions would warrant a Security Clearance Revocation? Is excessive debt one of them?  Yes.  Financial considerations may warrant the revocation of a service member’s Security Clearance.  This includes a history of not meeting financial obligations, such as the unwillingness to satisfy debts or submitting late payments on the service member’s Government Travel Charge Card (GTCC).  Unauthorized use of a GTCC by any one other than the service member (i.e., the service member’s spouse) may also prompt the revocation of the service member’s Security Clearance.  In addition, income tax evasion and illegal financial practices all merit a Security Clearance revocation.

The Future

Fast-forward five years.  You want to purchase a home.  How do you think your ability to borrow will look?

The key is to start planning now to reduce debt so you can be a potentially favorable borrower in the future.  Lenders look at a borrower’s ability to pay for a mortgage based on income and debt.  Lenders use the Front-End Ratio, in conjunction with the Back-End Ratio to approve mortgages.

  • Front-End Ratio.  A ratio that indicates what portion of an individual’s income is used to make mortgage payments.  It basically assesses the borrower’s ability to pay a mortgage by comparing total annual expenses for housing with the loan applicant’s gross annual income.  Total expenses should not exceed 25-29% of gross income.  The math: Front-End Ratio applying 28% of $45,000 gross annual income  = total annual expenses for housing should be less than $12,600 (0.28 x $45,000) or $1,050/month.
  • Back-End Ratio.  A ratio that indicates what portion of a person’s monthly income goes toward paying debts. Total monthly debt includes mortgage and credit card payments, child support and other loan payments.  Lenders require that monthly debt payments do not exceed 33-41%  of monthly gross income.  The math: Back-End Ratio applying 38% cannot exceed $1,425 in total monthly debt repayments ($45,000/12 ) x  0.38 = $1,425/month.

*   *   *

There is a bright-side to everyone’s financial future so long as credit is managed wisely.  That means living within your means but not over your needs.  Review your credit report yearly, spend less than you earn and continue to keep debt low if you want to save for future goals!




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