If you’re planning to purchase a home, you may be worried about your credit and how it will affect the financing of your house. A good credit score increases the likelihood of qualifying for a mortgage because it indicates to the lender that you’re more likely to make timely payments on your loan. It may also give you a better chance at a lower interest rate. Check out our tips for getting your credit ready for the homebuying process!
Get Your Free Credit Report
To prevent any surprises in your home-buying journey, check your credit report early on and stay on top of it. Federal law gives you the right to get a free credit report once a year from any of the three nationwide credit bureaus: Equifax, Experian and TransUnion. To order yours, visit AnnualCreditReport.com or call 1-877-322-8228. Your credit report will show any type of credit account reported to the credit reporting agencies under your social security number and payment history, and it is important to check it for accuracy, so that any potentially incorrect information doesn’t negatively impact your credit score.
Understand What Makes Up Your Credit Score
While your credit report will not include a credit score, you may also request one for free from any of the above organizations.
Many financial institutions, including Service Credit Union, will also provide you with a free credit score within online banking or on your monthly credit card statement. If you are not currently a Service CU member, but you apply for a mortgage with Service CU, you will also receive a credit score.
There are multiple types of credit score formulas, with FICO® and VantageScore being the two most popular. Your score may fluctuate slightly depending on the reporting agency and type of score used.
A credit score is a three-digit number that uses the information on your credit report to quantify the likelihood of repayment by reviewing how you have managed previous accounts. It is meant to reflect how risky it may be for a creditor to extend new credit to you. Scores generally range from 300 to 850, although it is possible to have a 0 if you have never had any credit history at all or if you have not had any open or active credit accounts in a while. The lower the credit score, the higher risk an individual appears to a creditor.
A FICO® credit score is calculated based on your loan payment history (35%), how much you owe (30%), length of credit history (15%), credit mix (10%) and new credit (10%).
So what does this mean, and how can you increase your score?
Making every credit card and loan payment on time every month is one of the best things you can do for your credit score. The second-largest factor, amount owed, positively affects your credit score if your loan balances are steadily decreasing, not hovering or increasing over time. The more credit limit you are using, the more risk you are to a creditor. If you have multiple credit cards, add up your balances and divide them by the total of your maximum limits and that’s your utilization rate. Ideally, you do not want to use more than 30% of your limits at any time.
Length of credit history looks at how long your credit accounts have been open. This includes the age of your oldest account, the age of your newest account, and an average of all your accounts. The longer your credit history, the better.
Up next is new credit, which reflects hard inquiries from credit card and loan applications. If you start applying for credit frequently, this can be a red flag to creditors because they may wonder why you need new credit cards and loan products so frequently. To avoid being penalized, be strategic about when and how often you apply for credit cards and loans. Hard inquiries typically remain on your credit report for 2 years.
Finally, credit mix is the last factor that impacts your credit score. Creditors want to see that you have a history of managing different forms of credit at the same time – for example, maybe a credit card and a car loan and a student loan. This is one of the smallest factors impacting your score, but it can help to have a well-rounded mixture of types of credit when they are all managed responsibly.
Your credit score can change over time, depending on your conduct and how your credit history and payment patterns change. The better the score, the better the loan terms offered to you.
The bottom line: lenders want to see if you are responsible with paying your bills on time.
Use it or Lose It
Credit is like a muscle – you have to use it!
If you don’t have much of a credit history, start by opening a credit card, and making regular payments on it. If you do have existing credit cards that you don’t use, keep them open. Keeping the account active helps boost the length of your credit history, which will positively affect your credit score. Of course, in some cases, such as if the card has an annual fee and you no longer use it, you may want to close the card to save money, but if you can avoid canceling your card until after your mortgage closes, do so.
Pay Off Smaller Debts
Your debt-to-income ratio is another important factor lenders consider when you apply for a mortgage. The ratio is calculated by dividing your total monthly debt payments by your gross monthly income (or net income if you are self-employed). For example, if you have debt payments equaling $1000 every month and your gross income is $4,000 a month, your debt-to-income ratio is 25%. The standard recommendation for lenders is that borrowers shouldn’t have a debt-to-income ratio higher than 43%.
If you have a loan with a small balance left on it, now may be the time to pay it off, so that your debt-to-income ratio drops. However, note that in certain cases, paying off a debt can (temporarily) lower your credit score if removing that debt impacts other credit score factors, such as length of credit or credit mix.
Attend a Class
At Service Credit Union, we are proud to offer free webinars for first-time homebuyers. Visit servicecu.org/learn to find an upcoming class, including our March 20 webinar, Getting Credit Ready to Buy a Home!