There’s a fair amount of confusion in the marketplace regarding the credit score used when applying for a mortgage. There are some sites, like Credit Karma, that provide free scores – available at a click.
Many consumers are shocked to find out that their Credit Karma or other online score do
esn’t match their FICO score, once they’ve talked with their mortgage lender.
But what are the differences and which credit scores do mortgage lenders actually use? The answer might surprise you.
I can’t stress strongly enough that potential borrowers should always work with the right mortgage lender when accessing credit for their next mortgage application.
Another thing to keep in mind, the strategy for achieving a good score remains the same, regardless of the type of scoring: paying bills on time and keeping balances low. Conversely, paying late or using too much of your credit limit lowers your score.
For more, see The Fortunate Investor, Tim Parker at Investopedia, and Brian Nelson at The Finance Gourmet
Here’s a primer on how different companies calculate these scores – and what your really need to know about credit.
What is it?
First, a credit score is nothing more than a number calculated from information in a person’s credit report. The idea behind a credit score is to determine via algorithms how good of a credit risk someone is without actually have to read through the details of a lengthy credit report.
The resulting number is only as good as the math that created it. The more statistically accurate the number is, the better the score is.
As most are aware, if you are applying for a mortgage, your credit score will be a critical part of the process. You could get rejected with a credit score that is too low. And once approved, your score will determine the interest rate charged. Someone with a 620 might have to pay an interest rate that is as much as 3% higher than someone with a 740.
The Credit Karma Model
If you get a free credit score from a website like Credit Karma, you are receiving the VantageScore – which is not the same as the FICO score, used by mortgage companies. I’ll outline the distinct differences later in the discussion.
Credit Karma, according to its website, believes borrowers have a right to know and view their credit scores.
The logic is that armed with this knowledge: potential borrowers are more likely to pay their bills on time and avoid going into collections for debt, and might waste fewer resources of the companies with whom they do business.
With that said, it’s not entirely an altruistic effort. Credit Karma is a for-profit business; sure, it is offering you something for free, but it is making money elsewhere. There really is no such thing as a free lunch.
From Tim Parker at Investopedia:
“The company’s revenue model for customers, posted online, reads: ‘When you access the free credit score, Credit Karma will show personalized offers to you based on your credit profile. These offers are from advertisers who share our vision of consumer empowerment. If you wish to take advantage of our offers, it is up to you. Credit Karma tries to give the power and the choice back to the consumer.’”
“Credit Karma makes its money in two ways. First, along with your credit score, it places advertisements on the page and hopes that you will respond to those ads. Second, because Credit Karma is pulling your credit score, its system knows a lot about you, and it can carefully tailor ads to your spending habits”
“More targeted ads are better for advertisers (they don’t waste money putting ads in front of people who would never use their services) and usually allow the advertising company to charge more per ad. With more than 40 million active users, Credit Karma has a healthy revenue model.”
The FICO Model
When most people think of credit scores, the probably think of FICO scores — the ones produced and sold by Fair Isaac Corp. They’ve been around for decades, and they’re used in about 90% of loan decisions.
Fair Isaac was the first company to popularize the concept of a credit score and is really only one credit score that matters in the mortgage world.
Over the years, it has demonstrated that its credit score algorithm is accurate enough statistically for financial investors to use it in determining risk. When it comes to actual lending, the gold standard is the FICO score.
However, the company was forced by Congress to provide a little bit of transparency into the process of calculating a score by providing some general information as to what a FICO is based on, and just as importantly, what it is not based on.
Starting from there, numerous entities have tried to develop an algorithm for creating credit scores that generates a similar score to the official FICO score. Doing so requires reverse engineering the mathematics that go into the score. No one has exactly duplicated the score, but many alternate scores provide a close approximation.
Differences in Models
One of the main differences is the calculation of how recently a credit account was used. Under the FICO system, accounts have to have been active in the last six months for their data to be fed into the algorithm. VantageScore takes a more comprehensive view and looks back more than 24 months, before churning out a final number.
Image courtesy of The Fortunate Investor
Another big difference is the way in which VantageScore and FICO go about using alternative data. VantageScore, for instance, includes things like utility and rent payments in its calculations, so long as they’re reported.
Both entities differ in another important way too: they way they deal with paid-off collections. Paid-off collections stay on your credit report for seven years, but VantageScore disregards them for scoring purposes.
However, the most popular FICO product does not, and will take into account any paid-off collections on your credit report. Clearly, this could significantly impact your score.
Finally, the reporting methods differ in how long they take before they calculate your credit score. FICO needs at least three to four months in order to come up with a score whereas VantageScore claims it can produce reliable statistics after just 30 days.
Of course, whether lenders believe any of this is up to them. Some might prefer a longer run in before relying on a credit assessment, others might just want something as quickly as possible, no matter how provisional it might be.
In Conclusion
Knowing your “real credit score” when you are not applying for credit is not very useful. Your score changes every day, so even if you get your official, 100% accurate, FICO score on Monday, by Friday your score may be up or down several points.
In other words, don’t stress out about the exact number. Instead, focus on making the number go higher, or at least stay the same.
Here’s a great piece on how to dramatically impact your credit score for the better – 5 Ways to Raise Your Credit Score Today.
With that said, it’s the FICO model that’s utilized for mortgage related purposes. Although Credit Karma’s VantageScore might give you a decent ballpark score, it won’t matter when applying for a mortgage. Make sure to know your actual FICO score prior to applying for a home loan – and I’d be happy to help you along the way!
Photo Credit: Cafe Credit via Flickr, under the Creative Commons License
