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Qualifying without perfect credit: Steps you can take to make your score stronger

Qualifying without perfect credit: Steps you can take to make your score stronger

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Your credit score is a statistical calculation designed to reflect your likelihood to repay your debts.

Most of us don't have perfect credit. Fortunately it doesn't take perfect credit to qualify for a mortgage. This week we're going to look at factors that affect your credit score and how negative items on your credit report can affect your credit score.

Your credit score is a statistical calculation designed to reflect your likelihood to repay your debts. The developers of the FICO score haven't revealed the exact formula used to compute the score, but they have identified factors that affect your score. They also have provided the relative weights of these factors:

35%: Whether you pay your bills on time
30%: How much of your available credit you are using ("credit utilization")
15%: Age of your credit accounts
10%: Types of credit used
10%: Recent credit inquiries

Based on the list above, you can see that the most influential factor is paying your bills on time. The FICO creators performed a simulation last year to determine the effect of "failure to pay" on a credit score. While the effect depends on one's starting score, the simulation showed that paying your mortgage 30 days late can drop your score between 80 and 110 points. A foreclosure may drop your score up to 160 points, and a bankruptcy a whopping 240 points.

It is important to note that once a negative item appears on your credit report, it stays there for seven years, 10 years for a bankruptcy. However, over time, the effects of negative items wane. The time to recover depends on the significance of the negative mark. In the FICO simulation, researchers found it took 9 months to 3 years for your score to recover from a mortgage late payment.

Even if your score is okay, it's important to recognize that certain negative items may disqualify you for some loan programs. After a Chapter 7 bankruptcy, you typically are ineligible for a government loan (FHA, VA, USDA) for two years and for a conventional loan for four years. For a Chapter 11 bankruptcy two years must elapse from the discharge or dismissal date to qualify for a conventional loan. A foreclosure or deed-in-lieu of foreclosure will sideline you for three years for government loans and two to seven years for conventional loans.

It is important to note that once a negative item appears on your credit report, it stays there for seven years, 10 years for a bankruptcy. 

These are extreme financial events. A more common negative item is a collection, and here the news is better. You generally can qualify for a conventional loan with outstanding collections as long as they don't affect the mortgage lender's rights. Collections on medical and utility bills usually fall in this category.

FHA recently changed its guidelines regarding collections. If you have collections totaling $1000 or more, you must pay them in full or have established a payment plan to qualify for an FHA loan. (This is a huge change from previous guidelines, and FHA seems to be backtracking a little. In fact, FHA just delayed implementation of the change until July 1st.)

Another common negative item is a late payment. I have fielded many a call from consumers concerned that they've done irreparable harm to their credit scores because they paid their car loan a couple days late. While you need to understand that a payment is late when not paid by the due date, creditors typically do not report accounts as late unless a payment is not received by the next due date. Thus, while forgetting to pay the credit card bill for a week will cost you a late fee, it probably won't ding your credit score.

A single late payment probably won't keep you from qualifying for a mortgage. However, if your credit report shows numerous recent late payments, you will find qualifying difficult. You generally will not be eligible for a conventional loan if your mortgage has been late by more than 60 days within the past year.

Government guidelines are a little more foregiving. However, multiple late payments on any accounts in the last year or a single payment that was late by 90 days or more may disqualify you.

This is a necessarily brief summary of the effects of negative items. If your credit report contains negative items, check with a mortgage professional to analyze your specific situation. Don't assume you won't qualify.

Note that the last factor in the list above is recent credit inquiries. Many consumers have expressed concern that this prevents them from shopping lenders for the best rate because each lender will make a credit inquiry. The FICO model anticipates this and ignores mortgage company inquiries for the 30 days prior to the report. Furthermore, for inquiries older than 30 days, the model treats them as one inquiry if they occurred within a "focused period of time, such as 45 days."

Next week we'll investigate ways you can improve your credit score based on an enlightening interview with a credit repair expert.