As real estate investors build their portfolios, a solid FICO score is an important tool needed to access capital at the best rates and terms. The best way to maximize a return on investment (ROI) is to improve the position of creditworthiness for pre-qualification and approval.
A FICO score is based on credit history and the responsible management of it. This article will explain how FICO scores work, the importance of a solid and manageable credit load, and how to repair a FICO score from a negative metric.
Key Takeaways
- FICO is the acronym for today’s analytics company measuring and rating a consumer’s credit history
- FICO’s client base comprises lenders, businesses extending credit, and insurance companies
- FICO scores are not exclusive to lenders
- A consumer’s proactive actions to improve a FICO score will demonstrate good faith to creditors
- Time, patience, and discipline are needed to improve a FICO score
Defined Terms
- Credit utilization – the relationship between the outstanding debt and the available credit limit
- Hard pull – a creditor’s request to access a full report to evaluate risk and terms, thus affecting the FICO score to some degree
- Soft pull – often used by private lenders for pre-qualification and approval without affecting the FICO score
- Return on investment (ROI) – earnings on the initial capital invested
Before we begin with the guidance to improve a credit score, let’s review how FICO became an essential diagnostic tool used by traditional and private lenders to manage risk.
FICO: Then and Now
FICO, the acronym for the Fair Isaac Corporation, was founded in 1956 by Bill Fair (the engineer) and Earl Isaac (the mathematician).
Today, FICO is a major analytics software company holding over 300 patents in the U.S. and worldwide with a client base of banks, retailers, businesses, and insurance companies. FICO has expanded its services to fraud protection, debt collections, strategy planning, and compliance.
The Importance of a FICO Score
A credit score ranging from 300-850 measures and rates a consumer’s credit history and potential for default. The components of credit history are the number of accounts, repayment behaviors, and the level of debt when compared to available credit.
How Credit Scores Work
A FICO score is important because the interpretation affects a consumer’s financial life and a borrower’s access to capital.
A consumer with a score of 670 and below can be considered “subprime.” Lenders underwriting subprime borrowers will view the account as risky and will quote higher interest rates and shorter repayment periods.
These non-competitive terms will compensate a lender for what it perceives as a risk-based loan. This, of course, assumes a loan will be approved and funded.
Consumers with a score of 670 and above are considered “good.” A lender’s underwriting will result in a lower quoted rate over a longer repayment period. A potential borrower with a score of 700+ will generally be pre-qualified for a loan before an asset and the merits of a transaction are known.
Every lender, creditor, and retailer will have their own definitions of subprime, good, and excellent. The FICO ranges and categories typically used are:
- Excellent: 800-850
- Very Good: 740-799
- Good: 670-739
- Fair: 580-669
- Poor: 300-579
FICO scores are also a factor in an employment application and in determining deposit requirements on utility accounts. Credit scores are not exclusive to lenders.
How a Score is Calculated
There are three major credit reporting agencies in the U.S.: 1) Experian, 2) Equifax, and 3) TransUnion. These agencies store, report, and update consumer credit histories. Credit reporting agencies calculate FICO scores from five main factors:
- Payment history
- Debt utilization
- Length of history
- Credit types, and
- New accounts and inquiries
A consumer’s history of payments shows if obligations are paid on time, which constitutes 35% of the score. The amount of credit a consumer has outstanding against the amount of available credit is known as credit utilization. This metric makes up 30% of the score.
A longer credit history is evaluated as less risky because there is more data from which to determine the history and repayment behavior. The length of credit history is 15% of the score.
The lesser components of the FICO score are the types of credit, new accounts, and inquiries. The types of credit include car loans, revolving credit, and mortgages.
New accounts include the metric of inquiries. Inquiries mean the new accounts recently applied or when a “credit is pulled.” While only 10% of the score, a 10% negative rate can seriously affect a consumer’s creditworthiness if there are “dings” in the other weighted categories.
Often, when institutional private lenders pull the credit of a potential borrower for either pre-qualification or approval, these pulls are “soft” meaning the FICO score will not be affected.
The above provides an overview of how FICO came to be, how a score is calculated, and its importance in areas of life other than access to capital.
Improving the Score
FICO scores can be improved. With the knowledge of the components and the calculation methods, a consumer can plan a strategic path forward to raise their score.
There are five proactive steps a consumer can take to understand their score and implement ways to improve it. These steps are:
- Check the credit report
- Improve the payment history
- Gain an understanding of credit utilization
- Take proactive measures toward collections, and
- Gain an understanding of credit mix and inquiries.
These strategies are discussed below.
1. Check the Credit Report
Every consumer is entitled to a free credit report from the three named agencies every twelve months. Knowing the contents of a credit report is to target any potential negative ratings to confirm the accuracy of the content.
If an error is found, then the best advice is to contact the bureau reporting the error and enter a dispute. The narrative given by the consumer will become a part of the record. The narrative will alert creditors that the information may have been reported in error and will show the reason for the dispute.
This diligence will directly improve a score.
2. Improve Payment History
This component carries the most weight in calculating a FICO score. Late payments will remain on a report for 7 years and will have the same negative effect as a missed payment. This step can be attended to by setting up auto-pay options. Make sure, though, that the day of the automated withdrawals will be the day funds are available.
If an auto-pay does not process due to insufficient funds, this will count as either a late or a missed payment. There could also be additional charges for insufficient funds or missed payments.
While it’s ideal to pay a balance in full each month on revolving credit accounts, it is understandable that this cannot always be done. An account will maintain a good standing even when minimum payments are timely made.
3. Understand Credit Utilization
The debt-to-credit ratio, or credit utilization, refers to revolving credit. The ratio is the relationship between the amount of outstanding debt against the total amount of credit available. FICO measures an average credit utilization of 7%. A low utilization ratio illustrates that the consumer is responsible and not over-extended.
This 7% average score is the goal. Credit utilization is the second most weighted component of the score and, the closer to this 7% goal, the faster the score will improve.
A sure way to lower the ratio is to increase the limit on revolving credit accounts. The trick is to not over-
spend on this increased limit and keep the debt-to-credit ratio near 7%.
Some consumers believe it is best to cancel accounts. This can be true, but credit utilization and history must be considered. The canceling of older accounts will decrease the available credit and shorten the credit history period. Both of these will negatively affect a score even with a perfect payment record.
4. Be Proactive Toward Collections
An account in collections may be added to your record as a separate delinquent account. This negative impact on a score will decrease over time. However, the rate of the decrease will accelerate if the consumer adopts responsible habits.
It is good practice to reach out to past creditors to either pay the debt in full or establish a payment plan. However, always ensure the account is valid by requesting a verification letter from the creditor before any payment is made.
Payments to collection agencies should not be made until the original creditor is contacted to confirm that the right collection agency is shown, and the original debt balance is confirmed to the extent possible. The debt amount shown on the credit report may include interest and fees.
5. Understand Credit Mix and Inquiries
a. Account Age
A FICO score increases with time, and the longer an account remains open and in good standing, the better the score. It is good to keep older accounts active. It must be remembered that retailers and banks can close an account after a period of non-use.
b. Credit Mix
A sustainable blend of installment and revolving credit will illustrate how well a consumer can manage all credit types. The mix includes mortgages, car loans, credit cards, student debt, and personal credit lines. A variety of credit types in good standing will improve the FICO score.
c. New Credit and Inquiries
Consumers who do not have a long credit history need to be mindful of the fact that applying for new credit over a short time period will be a negative metric against the score.
Also, the number of “hard pulls” within a short time will be a detriment. A hard pull means that a creditor has requested access to the complete report to evaluate risk and credit terms. The number of hard pulls will remain on the report for two years and will have an effect on the score for one year.
Private lenders can pull “soft” inquiries for a pre-qualification, or a potential employer can do the same as a part of a background check. Soft inquiries do not affect the score.
As an alternative to the “soft” pull inquiries, you can also check where your current credit score is standing through Credit Karma. It offers two ACTUAL (Not Estimate) credit scores from TransUnion and Equifax (i.e. 2 out of 3 credit bureaus): a) free of charge, b) no adverse impact on credit scores, c) easy to follow and use.
Most lenders adopt the median credit score for their underwriting. Therefore, if you share with the lender the lower of the two credit scores obtained from Credit Karma during the beginning stage, you won’t have any surprise when the hard pull inquiry is made later on.
With the information given above and the knowledge of the components of a FICO score, a consumer can now time the opening of new accounts, use older accounts enough to keep them active and in good standing, and proactively approach debts in collection.
Conclusion
The crux of this article is that time will improve a credit score. However, anything a consumer can do on their own initiative will hasten an improved score and will show good faith to creditors. An excellent FICO score takes discipline and patience.
For investors with the goal of growing their portfolios and creating wealth, access to capital on competitive terms and leverage ratios is the best way to maximize ROI.
Time, discipline, and consistency must be the underlying characteristics of any consumer when managing credit and maintaining a solid FICO score.
