Today's Credit Scoring Basics and the Effects on Construction Financing

At one time, not too long ago, there was no such thing as a numeric credit score. Your credit report either showed that you paid on time or you didn't, and that was that. You were approved if you had a good rating and were denied if you had a bad rating.

Times have changed. Computerized credit reporting has made it possible to nearly instantly report good or bad information about you and your risk as a borrower. In the mid 1990's, numeric credit scores appeared on the lending scene. Today, credit scores are used nearly exclusively to determine your credit worthiness.

Construction loans are a bit tougher to qualify for than typical purchase or refinance mortgages. You will be held to higher credit standards when seeking a construction loan, especially when requesting an owner builder construction loan (a loan to build your home without hiring a general contractor).

Remember, when seeking owner builder construction financing, you are asking a lender to make a very risky loan. They must assure themselves of your ability to repay the loan. One of the biggest ways of doing this is by examining your credit scores.

The most common credit score is called your "FICO" score, produced by the Fair Isaac Corporation. It is a number between 300 and 850 - the higher numbers being better. "FICO score" has become the generic name for "credit score." However, FICO is actually a type of brand name, similar to the way Xerox is used generically for photocopy machines.

Three credit bureaus that should be familiar to borrowers use a version of the FICO scoring system. They are Equifax, Experian and Trans Union. Nowadays, lenders almost universally pull a report that generates all three scores - one score from each bureau.

The scores are typically close to each other, but almost never exactly the same. Occasionally, depending on the information sent to each company, there could be a large spread between the scores. However, nearly all lenders use the middle score of the three as your application's score. The middle score is used, not the average and not the highest.

To make matters even more confusing, there are a few little known or discussed secrets that the credit scoring companies hid from us. One big secret, that nearly no one knows, is that your scores will be different, based on the type of credit you are seeking. For example, you will have a different score when you apply for a car loan versus applying for a mortgage.

You will also typically get a slightly different score when you run your credit yourself versus having a lender run it, as you will be receiving a score based on the "consumer" model instead of the lender model.

How does this happen? Your score is based on a "model" that different lending industries use. So, when you apply for a car loan, your scoring model is judging your ability to repay a car loan, based on previous car loan history and all your other credit history. This is also true for mortgages, insurance and a couple of other industries.

It is important to understand how your credit is being judged. The mortgage "model" will weigh your previous mortgage history more than your auto loan and other credit history. Just as your auto loan history will be more heavily weighed when applying for a car loan. However, all scoring models take many common things into consideration.

For example, in a credit report that has no derogatory entries, revolving debt, and your debt to available credit ratio, is usually the single biggest factor to the overall numeric score. This means that even with "perfect" credit, your score may not be as high as it should if you have too much revolving debt.

There is much misinformation circulating about credit scores and what you should and shouldn't do. But, the first step is understanding the basics of the credit reporting system. So, when you start to search for the right construction financing, whether you build with a general contractor or act as an owner builder, you will already know how the credit reporting system works.

Keep in mind the following general guidelines that most construction lenders follow:

1) The very best programs, rates and terms are reserved for those with credit scores over 720. However, if your other qualifications don't meet those program's guidelines, simply having a terrific credit score will not make up for it.

2) There are very few options for construction loan borrowers with scores below 620. For owner builders, the options are even tougher. And, all of these options will require very large cash down payments, in addition to having higher rates and fees.

3) Most of the programs for owner-builder construction loans require at least a 620 score, and many require a 680 or better. Typically, if you are at a 620 or better, you can qualify with very good terms.

4) No matter what your credit score, if you have had a late payment on any mortgage in the last 12 months, you will not qualify. Be very serious about paying your mortgage on time. Mortgage lenders hate it when they see that you don't pay your mortgage on time.

Now you should not only know some general trends that construction lenders use to qualify borrowers, but you should also understand the FICO scoring system and how it is used by the three credit bureaus - Equifax, Experian, and Trans Union.

Gone are the days of loans without numeric credit scores. With construction financing, and owner builder loans in particular, the credit score is one of the most important aspects of a borrower's loan qualification. So, please take it seriously and at least understand the basics.

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