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If you are going to borrow money to build your new custom home, that means you will typically have a construction loan and a conventional mortgage. Because a construction loan has more risk for a lender (who wants to foreclose on a half-built home?), the lender will usually charge a higher interest rate or more fees to compensate for the higher risk. They will typically also require a higher credit score for construction loans. This is their way to ensure the borrower is more likely to repay the loan. But how does a credit score work? Which credit score will they use? Do you know you actually have over 30 credit scores!? Let’s explore what this means to you.
What are Credit Bureaus?
Credit bureaus are organizations that collect and normalize information about an individual’s credit score and give that information to lending institutions. In the U.S., the main three credit bureaus are Experian, Equifax, and TransUnion. There are many smaller companies that also provide similar services.
The primary purpose of credit bureaus is to provide creditors with the information they need to make lending decisions. Clients of credit bureaus include banks, mortgage lenders, credit card companies, and other financing companies. Credit bureaus do not make credit decisions; they merely provide their data to those that can legally request it. To simplify the data, they aggregate it into a “scorecard” or scoring model, which is used to determine your credit score.
Types of Credit Scores
There are two main scoring systems for credit. The original and well-known one was developed by the Fair Isaac Company, now shortened to FICO. The company specializes in predictive analytics. They are experts at taking information from the three credit reporting bureaus and predicting which accounts will pay their bills (or not), file for bankruptcy, and who can handle a larger credit limit. Until 2006, FICO had no real competition. They were the standard credit scoring company.
In 2006 the industry of credit scoring became competitive when the three major credit reporting bureaus, Experian, TransUnion, and Equifax got together and jointly developed an algorithm to produce a new score – the VantageScore. The VantageScore is the score used by the popular credit sites Credit Karma and Credit Sesame, as well as several credit card companies that now provide free access to your credit score.
There are Versions of Credit Scores?
The job of a credit score model is to predict the borrower’s likelihood to repay the loan. It turns out that many times that is influenced by what you are buying or getting with your credit. For example, if a potential landlord pulls your credit score, they don’t care as much about unpaid medical bills because that is not indicative of the renter’s likelihood to pay rent. However, payment history with a previous landlord is. FICO has many credit models that it provides based on the purpose of the credit — for example, getting a credit card, buying a car, renting a home, or getting a mortgage.
Here is the complete list of each credit score version from myFICO along with a description:
FICO Score 8: The most widely used FICO score
FICO Score 5: Older version, most widely used for mortgage lending
FICO Score 4: Older version, most widely used for mortgage lending
FICO Score 2: Older version, most widely used for mortgage lending
FICO Auto Score 8: Used for auto lending
FICO Auto Score 5: Older version for auto lending
FICO Auto Score 4: Older version for auto lending
FICO Auto Score 2: Older version for auto lending
FICO Bankcard Score 8: Used for credit card lending
FICO Bankcard Score 5: Older version for credit card lending
FICO Bankcard Score 4: Older version for credit card lending
FICO Score 3: Older version primarily used for credit card lending
FICO Bankcard Score 2: An older version used for credit card lending
FICO Score 9: The newest available FICO score
FICO Auto Score 9: The newest available score for auto lending
FICO Bankcard Score 9: The newest available score for credit card lending
In addition, FICO is about to roll out two new scores soon, the FICO Score 10 and 10 T this summer. And remember, each credit bureau reports their version of each of the above scoring models.
The credit score you are getting from Credit Karma, Credit Sesame or your credit card company has no bearing on the actual credit score your mortgage lender is going to use. Fannie Mae requires the following versions of the classic FICO score for mortgage loans:
- Equifax Beacon® 5.0;
- Experian®/Fair Isaac Risk Model V2SM; and
- TransUnion FICO® Risk Score, Classic 04.
Beyond mortgages, FICO Score 8 is the most widely used score. Just recognize that you have dozens of scores. Now you know why the credit score you see has no bearing on the credit score that is being used to assess for credit extension decisions.
The More You Know…
While getting your credit score to be as high as possible prior to applying for a loan should be important, don’t get too hung up on which scoring model is going to be used. Most experts say that good credit is still about three things: paying your bills on time every time, keeping your balances as low as possible, and not applying for too much credit too often. Prior to applying for a construction loan here are two things you should do now:
- Reduce your credit utilization ratio: This measure of how much credit you’ve used versus how much credit lenders are willing to give you (particularly with credit cards) is a key component of credit scores. Keeping this low isn’t a matter of just paying your total monthly bill if you’re the type of person who maxes out their credit cards every month. Instead, consider making payments multiple times each month.
- Correct any errors on your credit report. It’s estimated that one in five Americans have an error in their credit report. Errors can pop up for any reason. In some cases, people have had errors in their report because a lender or credit bureau confused them for another customer with the same name. Getting these resolved quickly is important. Contact both the lender and credit bureaus to resolve issues as quickly as possible. Credit Karma will allow you to dispute many items with credit bureaus online.
While the credit score you see won’t match that of your lender, your goal is to present the best credit score you can to your lender. A good score will get you qualified for your new home construction loan at the lowest rate and best terms. Start today by getting your free credit reports from the bureaus and learning what your current scores are as you pursue the dream of building your new home.
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