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What is Credit and Why It’s Important

 

Credit refers to borrowing money or receiving something of value with a promise to pay back the amount at a future date, usually with added interest. It also signifies your trustworthiness to repay the loan under a credit agreement.

How Does Credit Work

Typically, a lender approves a person to borrow a certain amount of money. That money could be available to the borrower through a line of credit or lump sum. In exchange for borrowing the money, the borrower agrees to pay it back to the lender over a period of time, typically with interest.

Types of Credit

Type Description
Revolving credit Allows borrowers to use funds up to a specified limit, make payments and then access the funds again, offering financial flexibility. Credit cards are a prevalent example.
Installment credit Involves borrowing a set sum of money for specific purchases like homes or cars, which is then repaid through equal, regular payments over an agreed period until the debt is fully cleared.
Open credit Allows a borrower to repeatedly use funds up to a certain limit from a financial institution, similar to revolving credit but often designated for specific purposes, such as a store charge card.
Secured credit Type of credit backed by collateral. If the borrower fails to repay the loan, the lender has the right to seize the collateral as a means of recouping their loss.
Unsecured credit Type of credit that is issued without requiring the borrower to provide collateral as security. The lender relies on the borrower's creditworthiness and promise to repay, rather than having the ability to claim specific assets in the event of default.
Commercial credit Provided to businesses for funding their operational or capital expenditure needs. It helps companies manage cash flow, purchase equipment and finance expansion projects, among other uses.

Each type of credit serves different needs and has its own set of terms and conditions, eligibility criteria and repayment structures. The choice heavily depends on the borrower’s financial needs, creditworthiness and the purpose of the credit.

Credit Scoring Models

A numerical representation of a person's creditworthiness is known as a “credit score.” Credit scores serve as a quick reference for lenders, creditors, landlords and others to evaluate the risk associated with extending credit or services to an individual. Several factors influence the score and can vary among different credit bureaus.

Three major credit reporting agencies (CRAs) for credit scoring are Equifax, Experian and TransUnion. You’ll sometimes hear them called the “Big Three.” Many of the lenders that offer you credit will turn around and report how you use it to one, two or all three of these credit reporting companies.

Not all creditors report to all three credit bureaus, so you may have a different credit report at each. What can be even more confusing for consumers is you don’t have just one credit score. In fact, there are dozens of credit scores out there.

Different Credit Scoring Methods

Many people believe that when they purchase a credit score from a credit monitoring service, they have access to the same information as a potential lender. Unfortunately, this is often not the case because CRAs don't share credit information.

Even companies that use the same credit scale may not come up with identical scores. This is because consumers and lenders have different models and formulas that emphasize specific aspects of a consumer's credit history.

You do not have a universal credit score. The number you receive depends on the scoring method and the loan or credit you are applying for. Here is a quick rundown of the most common methods:

  • FICO Score: The Fair Isaac Corp. score is the standard for many lenders.
  • VantageScore: Co-developed by TransUnion, Equifax, and Experian, this model combines data from all three CRAs.
  • Educational score: Each CRA also has its own proprietary scoring model. While not used by creditors, these scores are designed to help consumers manage debt, identify problems and minimize identity theft. Most credit monitoring services fall under this category.

The truth is that you could spend hundreds of dollars finding and documenting your credit score through each one of these services and still not come up with the same number as your lender.

What credit score is used for a mortgage?

When we talk about VA home loans and the mortgage industry as a whole, we’re usually talking about one type of credit score in particular. That’s called the FICO score, which falls on a range from 300 to 850.

The FICO score relies on your credit information from each of the three credit bureaus. FICO uses sophisticated modeling and software to create scores for specific forms of borrowing, including car loans, credit cards and mortgages. Each of the three credit bureaus can use a slightly different FICO scoring formula to create your score.

That’s a big reason why lenders will pull your mortgage-focused credit scores from all three credit bureaus and use the middle, or median, score as your credit score. It’s also why consumers often see different credit scores than what lenders see.

When you purchase or otherwise get a look at your credit scores from FICO or other agencies, you typically see a broad-based “educational” score. That’s a more basic credit score, and it’s often different from the industry-specific scores mortgage lenders will see.

How is your credit score calculated?

The FICO credit score condenses your entire history as a borrower into a tidy three-digit number. FICO doesn’t reveal exactly how it formulates a credit score. But the company provides a broader look at how it all comes together.

Understanding what makes up your credit score can help improve your score when trying to buy a home. Let’s take a look at the five big factors that make up your FICO score:

Payment History (35% of your score)

Your payment history accounts for the single largest portion of your score. Your track record as a borrower tells a potential lender a lot about how you handle credit. The payment history portion considers the number of timely payments, late payments and number of adverse credit items, including bankruptcy, judgments, liens, past due accounts and items in collection.

Amounts Owed (30%)

Having some debt isn’t necessarily a bad thing. However, having too much in relation to your available credit can drag down your score. There are different rules of thumb, but generally, try to keep your amounts owed to about 30 percent or less of your total available credit. Think of it as a balance-to-limit ratio on your credit cards.

Length of Credit History (15%)

The next largest slice of your score is devoted to the length of your credit history. A longer credit track record will usually bump up your score. FICO scores consider the age of your oldest and new credit accounts, the average age of your accounts and how frequently some accounts are used.

Types of Credit Used (10%)

The FICO score looks at the different types of credit you use, from credit cards and retail accounts to installment loans and mortgages. Opening new credit accounts for the sake of diversity isn’t likely to help your score. FICO says your credit mix isn’t usually a key factor, but it can become important if you don’t have much in the way of a credit history.

New Credit (10%)

The FICO score looks at your number of new accounts, the type and the frequency with which they were opened. A flurry of new loans or credit inquiries could signal a desperate grab for credit, so be cautious when opening new accounts. Applying for new credit may not hurt your score, and if it does, it’s typically a small impact.

FICO also allows for rate shopping within a 45-day window, meaning your credit score won’t plummet if you seek loan preapproval from multiple mortgage lenders. The credit bureaus will treat all credit pulls within that time frame as just one big inquiry.

Veterans United Credit Scoring

Like most mortgage lenders, Veterans United uses what’s known as a tri-merge credit report. This report shows your credit history and mortgage credit score from each of the three credit bureaus (Equifax, Experian and TransUnion). All borrowers must have a tri-merge credit report with a minimum of 1 FICO score.

We will use the median (middle) of the three scores as your credit score for loan qualification purposes. For example, if your Equifax score is 600, your Experian score is 620 and your TransUnion score is 625, we would use the 620 from Experian as your score. Our minimum credit score requirement is 600.

Credit score minimums can vary by lender, loan type and other factors. The good news is VA loans often have lower credit score benchmarks than other loan types.

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