Your Guide to Credit Ratings

This is a guide designed to help you assess your credit rating score and understand what you can expect to receive from a lender, in the form of interest rates and fees.  Please keep in mind this is only a general guide and some lenders use their own method of evaluation and credit score grading.  Your actual FICO credit score is only one component of the "grade" that a lender assigns to you.  The components that make up your grade are: types of credit history, debt ratio, LTV ratio and credit score number.

Types of Credit History

Credit can generally be broken down into three categories: mortgage credit, consumer credit and public records.

Mortgage credit.  Your specific payment history on existing and previous mortgages.  The past history of payments made on a mortgage loan can be a good indicator of a borrowers attitude toward mortgage obligations.  Payment history on mortgage debt is very important when lenders are determining your credit grade.  If you've never owned a home before, this type of credit will not be applicable to you.

Consumer credit.  This category covers revolving credit and installment loans.  Examples of installment loans are longer term credit with structured payment plans, like auto loans and student loans.  Revolving credit examples are lines of credit, financial institution credit cards and home center credit cards.

Public records.  The third category covers public records related to your credit, such as bankruptcies, collections and foreclosures.  A borrower with an "A" grade would not have any bankruptcy within the past 2 to 10 years.  Meanwhile, a "D" grade borrower could currently be in bankruptcy. 

As a general rule, the more serious the borrower's credit problems, the lower the credit score, and the lower the grade the lender will assign to the borrower.  As the grade decreases, the borrowers cost will increase (in the form of higher rates and fees) because the borrower is seen as higher risk to the lender.

Debt Ratio

Upon applying for a mortgage, a lender will review the capacity of the borrower to repay the mortgage loan.  Lenders calculate the debt ratio by summing up all of the borrowers monthly debt service payments and divide it by the total monthly income.  You can read more about this calculation in our other article, here.  If a borrower has a low debt ratio, the grade assigned by the lender will be higher.  Alternatively, if the debt ratio is high, the grade score will be low.

LTV Ratio

Loan-to-value (LTV) ratio is the mortgage loan amount divided by the appraised value (or purchase price, whatever is less) of the home.  An easy example is, a loan amount of $200,000 on a purchase price of $400,000 equals an LTV of 50%.  The higher the LTV ratio, the more risk the lender is exposed to and therefore the lower the grade they will assign to a borrower.  There are restrictions on LTV ratios in most cases.  For example, most refinancing situations are limited to a maximum loan amount of 80% LTV.  There are other LTV restrictions when purchasing a home, ask your broker for details.  In general, a better credit grade will equal a higher LTV ratio that you're able to secure for your mortgage loan.

FICO Credit Score

The most common credit indicator is known as your FICO score.  The higher the number, the lower the credit risk you present to a lender.

FICO stands for Fair Isaac Company, which is the company that created the original scoring system.  Each credit reporting bureau has its own unique system that allows them to offer a score based solely on the content of their individual bureau's data.  Even though there are different credit reporting bureaus, the numerical score you get from one bureau is based on the same scale as every other bureau.  So although the data available at each bureau may be slightly different, they all report the scores on the same scale.  The scores range from 375 to 900 points, and in general, a score of 650 or above indicates a good credit history.  Average FICO scores fall into the range between 620 and 650.  It should be noted that not all lenders give the same value to a particular credit score number.

Now that you know the factors that make up the "grade" assigned to you by a lender, you can estimate what to receive in the form of interest rates and fees.  The highest possible grade (good scores/results for every factor) will receive the best interest rate.  As your grade decreases, the interest rate you'll receive increases, along with the potential for fees you'll need to pay in order to close the mortgage loan.

If you feel like your grade might not be the best, there may be other compensating factors that help your overall application package, like a history of savings, long-term job stability, history of making monthly payments that meet or exceed the proposed mortgage payments, a large down payment or a large pay out received after the close of a settlement.