You’ve worked hard to perfect your credit. As a result you expect the home loan process to be hurdle free! Then, using a giant magnifying glass worthy of Guinness Book of World Records accolades your lender scrutinizes your credit. Finally, you get a new home loan! A few months later, after all that work your credit score seems to suddenly take a dip after your new home loan closed.
How Do Credit Bureaus Determine Credit Scores
Does the above seem strange? While on the surface it appears counter intuitive there is rhyme and reason it. Credit is a mortgage lender’s eyes and ears when it comes to finding risk. A consumer’s credit report allows creditors to see how much of a credit risk someone as well as how likely are they to make their payments. First, let’s look this 8th wonder of the world we call credit and how it thinks.
- A persons debt load
- A consumer’s historical payment performance
- Individuals credit balance and usage
- The number of times someone applies for new credit
While each of the 3 major credit bureaus algorithms are slightly different they are conceptually very similar.
Why a New Mortgage Lowers Your Credit Scores
Imagine that you are considering lending money to your friend. They’ve promised to pay you back in equal monthly installments. Originally, your friend requested this loan 30 days ago fro you. At that time they lived with their parents. No monthly rent and no monthly mortgage payment. As a result they had plenty of cash to pay you back with. Suddenly, the week before you lend them money you find out they just bought their first home. They also have their first mortgage payment – $1500 a month. Knowing this, do you feel any different about lending them money?
Fast forward 6 months. This same friend is painting their house, planting flowers in their front yard AND they are making all mortgage payments on time. In addition, your friend has not complained about making their mortgage payments nor has it been difficult for them to make them. Based on these observations 6 months later you decide to lend your friend money and feel confident that they will pay you back. You, in this story were a credit bureau.
Credit Bureaus Filter All Data To Establish Risk
Just like you, credit bureaus take in all the data they can on a consumer. Then, that data is evaluated and turned into your credit score. In other words, the data is converted into a way of telling the world what kind of credit risk you are. The difference between you and the credit bureaus is the credit bureaus do not hang out or talk with your friend. Instead, they make assumptions and interpretations based on hard data to arrive at the same conclusions you did when lending them money.
You see, no one calls the credit bureaus to say “I may have some trouble making my new mortgage payment.” Instead, credit bureaus temporarily drop a persons credit score after a new mortgage appears on their credit. This is their way of tell creditors “this person may not be a great risk right now because they have new significant debt and a new significant monthly payment.” Then, after a few months of on time payments credit bureaus start to raise the new home-buyers’ credit score. This is how the credit bureaus says “ok, this person can handle their new mortgage payment no problem.”
Several factors go into this scenario. Everyone’s credit score reacts differently to a new mortgage. Credit is a very detailed system. However, general rules like what we covered here that can help you make the best of your credit!
By Jeremy House