Credit is Money. And Vice Versa.

"How is your credit?"

Thump. thumpthump. Thump.

Few words evoke such a visceral, in-the-gut response to those seeking a home loan, and for good reason. Your credit score, as you probably know, is the single most important factor in obtaining a home loan. It is more important than how much money you make. It is more important than how long you have held your job. It is more important than how much money you have in the bank.

To put the importance of credit score into even clearer focus: If you have NO JOB, but excellent to near-perfect credit, you can get a mortgage to buy a house (true, you will need a down payment.) Ponder that for a second, because it is pretty amazing if you think about it. An institution will loan hundreds of thousands of dollars based almost entirely on three little numbers.

But the meaning of your credit score goes beyond the simple calculus of getting (or not getting) a home loan. It is what the credit score implies about you as a person that carries so much emotional baggage. If you have good credit, you’ve likely worked hard and made some sacrifices to make it so. If you have bad credit, it can serve as a constant reminder of poor decisions, bad luck, or financial shortcomings. Your credit is a measure of your financial security. But it is also measure of who you are as a person, and the quality of your word. Ultimately, it is an expression of what dreams the world will allow you to pursue. Or at least that’s the way it can feel.

Credit score, credit report, credit rating, credit bureau, credit inquiries. Credit, credit, credit. The world is awash in credit and it increasingly permeates our everyday lives. All lenders use it to make loan decisions. Insurance companies use it to determine rates. Your future employers want to use it as a measure of your character. People want to steal it. Credit is currency, and all things considered, it’s some of the most valuable currency you have.

But that is all big picture credit stuff. There’s lots of good information out there, and many thousands of words are written each year about all things credit related.

What I’d like to do here is focus on the little picture for a moment, and relate an experience I recently had with a client that speaks to one of the flaws in this credit reporting system that we have all, lenders and borrowers alike, come to rely upon so much. We’ll call it:

Installment 1 in The Annals of Absolutely Ridiculous Things that Can Go Wrong Even When You Do Everything Right (TAARTTCGWEWYDER for short.)

This is a true story, I’ve changed the names and any other identifying information for the sake of privacy.

Jim and Marilyn were a young couple who just had their first baby, and were looking to move up to a larger home. I’d arranged the loan on their first home and, smart folks that they are, they came back to do a little planning as to the type of mortgage they want and what they’d qualify for. Real standard stuff.

Based on their excellent credit and financial circumstances, we together decided that the best course of action was to use the proceeds from the sale of their home to pay off high cost debt, rather than make a large down payment on the new home. In their case, the loan we selected was a zero down loan using two separate loans to finance the entire purchase price of the property (This is known as an "80/20" or "Piggyback" loan.)

Now, the loan they selected requires excellent credit – so good in fact that most lenders require a certain minimum score (and remember there are two lenders: One for the first or "80" and another for the second or "20." Click this link for an explanation of an 80/20 or Piggyback loan.) At the time we made the decision, their credit scores were very good – with a 707 and 717 respectively (these are actually the middle of the three scores generated for each of them, and as we will see it is the LOWER of the two middle credit scores that really counts,) and easily more than the minimum required 680 credit score.

Fast forward a few months. House has been sold, but their new home won’t be ready for a number of weeks, so in the meantime they use the proceeds from the sale to pay down debt. Specifically, a couple of credit cards, an auto loan, and because the house was sold, the mortgage was obviously paid as well. All good ideas and exactly as we had planned. During this time no payments were late, and no erroneous data found its way onto their credit report. Two weeks before closing, we pull a credit report. The scores: 672 and 720.

Blink. Blink.

Try explaining to a client that even though they have not made a single payment late, and have paid off LITERALLY tens of thousands of dollars (hundreds of thousands if you count the mortgage) their credit score has gone down. Then try explaining the fact that because of this mysterious drop in score, that not only will the rate on at least the second mortgage go up, but there is some question as to whether the loan would be approved AT ALL. I know how I would react had someone told me this.

Now, the long and the short of it is that they closed on time, their second mortgage rate being significantly higher and approved only as an exception to standard policy. But they were lucky. This drop in one (middle) credit score could have easily cost them the whole deal. In fact, during the inevitable and understandable "Alex must be either trying to screw us or have no idea what’s going on so let’s call someone else" phone calls that they made, they could not find another lender even among some major national banks that could do this 80/20 loan for them as they had planned. Not one. I even helped them make the calls.

So, the moral of the story I suppose is more of a question: Why did the scores drop? It’s a great question, because they did everything right. Unfortunately there isn’t a great answer other than to say for all the ways our credit reporting system helps you, it is not perfect. Scores can change weekly, and sometimes move in directions that defy logic. Sometimes people with good credit have low scores. Sometimes people with bad credit have high scores.

Fortunately, situations like the one above are rare, and becoming more so as credit reporting standards and practices are improving. Just remember, credit is currency, and you need to protect it and watch over it like any other asset.

Related posts:

1. FICO: Quantifying the Damage, How Short Sales May Impact Credit Scores
2. Pain for Prime Borrowers: Fannie Mae, Freddie Mac to Hike Fees; or How a Three-Point Difference in Your Credit Score Could Cost You Thousands.
3. The Price of Average Credit just Went Up
4. Free Credit Reports (with a catch)
5. Minneapolis FICO Scores: King of the Hill, Top of the Heap