Understanding How Your Credit Is Scored

A post on the New York Times “Bucks” blog caught my eye last week, so I thought I’d share it.

Matt Haughey, who writes a personal blog called “A Whole Lotta Nothing”, voiced his displeasure with his current credit score, complaining that while he’s brought order to his fiscal existence, his credit score has dropped. Not surprisingly, this gave him reason to question the validity of the credit scoring system.

John Ulzheimer of smartcredit.com caught wind of the blog and instigated a back and forth with Haughey – not to defend the credit system – but to clear up some misconceptions. Ulzheimer makes some excellent points.

Many people focus on how much they make or their net worth, when trying to figure out what their credit score should be. In reality, it’s how much of a risk you are that determines your score.

Ulzheimer uses some excellent examples, which can be seen here.

It may or may not come as a surprise, but how a short sale will affect someone’s credit score is one of our more frequently asked questions. While it won’t have a dramatically better/more positive effect on your score than a foreclosure, it will show lenders that you made every effort to make the best of what was likely a bad situation.

More times than not, someone who has completed a short sale was faced with a personal or professional hardship, which prevented them from continuing to pay on their mortgage. Many simply walk away. For those who attempt to work with their lenders, it shows them in a far more positive light – they successfully mitigated the potential loss to the lender.

A large sect of those who recently completed a short sale will fall into a new category I blogged about back in March - “first time defaulters” (FTD’s): someone who had excellent credit prior to the housing collapse, but now find themselves with one glaring blemish – a short sale, a deed-in-lieu or worse, a foreclosure.

Many lenders are beginning to look at FTD’s in a favorable light for several reasons:

1) Odds are the borrower was a casualty of the market collapse, not the cause of it.

2) So many people have been affected by the collapse, few will be left in a favorable position to borrow based on the old credit scoring standards – where a housing related work-out or default would send someone to credit score purgatory.

Remember, lenders are in the business of lending money. They can only move it around internally or pay CEO bonuses for so long. At some point, they’ll need to start making money again and lending is the way to do that. If those who were historically ideal borrowers are now too small in numbers, FTD’s might be the best starting point for credit expansion.

How credit-scoring changes will be interesting to watch. In the meantime, work on your credit score within the current system by understanding how it works. It’s frustrating, but with the right knowledge, you can put yourself in a strong position even if your paycheck and savings account show otherwise…