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It doesn’t matter what you’re buying—your first home, a golf cart, or a college education—if you’re buying it on credit, it’s time to polish your credit profile.
Many borrowers don’t have a firm grasp of how good credit is built. So they’re not in the best position to raise their credit scores or shine up their credit reports when it comes time to purchase a new home. But once you break your credit score down into a handful of components, it’s not that complicated.
Why Your Credit Score Matters
Raising your credit score is a financial game changer. Depending on how much money you borrow, an excellent credit score can save you tens of thousands of dollars—or even hundreds of thousands of dollars over the years.
Let’s say you borrow $300,000 to buy a home and take out a 30-year mortgage. If you’re paying 4.5% in interest, your loan principal and interest payment will be about $1520 a month. But if you were able to shave just 1% off of your mortgage rate, your payment would be about $1347. Multiply that difference by the 360 payments you’ll make over 30 years. With that lower interest rate, you stand to save over $62,000 over the life of your loan.
So let’s look under the hood of your credit report. That’s the key to seeing what you look like in the eyes of a mortgage lender.
Start Raising Your Credit Score Now
Here’s the first thing you need to know. Those extra credit score points aren’t easy to earn. Taking your credit to the next level takes time. So ideally, you’ll begin working on improving your credit well in advance of applying for a mortgage, personal loan, or even a credit card.
What Do Credit Bureaus Care About? Components of Your Credit Score To credit novices, credit scores can be puzzling. And frustrating. It may seem like they’re determined willy-nilly, but it’s actually rather formulaic.
There are five primary measures that credit bureaus look at when assigning you a credit score. Improving your performance on any one of them can raise your score, but some factors are more influential than others. So let’s take them in order of importance.
● The number one measure credit bureaus use when they give you a score is your payment history. Your history of making on-time payments represents about 35% of your credit score. Falling behind on paying your credit card bills for just one month can tank your credit score. Late payments are recorded as negative remarks on your credit profile and they may appear on your credit report for up to seven years. Ouch!
The best thing you can do for your credit score is to make all payments on time. Don’t even think of applying for a mortgage unless you are up-to-date with all of your credit payments. Trim every bit of fat from your budget to bring all of your credit accounts into good standing—even if all you can do is make the minimum payment due. For many borrowers, it’s about getting organized. You may have the money to pay your bills on time, but you sometimes forget. But you can overcome disorganization. Use your mobile phone’s calendar app to set up payment alerts. Or you can take the old-fashioned route. Print out your bills and put them in a pile in order of their due dates. Check your “bill pile” every day and make payments 2 or three days in advance of their due dates, even if you pay them electronically. Electronic payments aren’t received by your lenders instantaneously. We can’t overestimate how important it is, when you’re trying to build your credit, to pay such close attention to credit account due dates.
● The next most influential factor in determining your credit score is your credit utilization ratio: the amount of money you owe compared to your credit limits. Ideally, you should keep your credit utilization ratio under 30%. You can improve your credit utilization ratio in one of two ways. Pay down your bills, prioritizing accounts that charge high interest. Or, if you have a great payment history, you can request an increase in your credit limits. Incidentally, requesting higher credit limits doesn’t lower your credit score.
Here's something counter-intuitive you may not know, though. A lower credit utilization ratio is better—but only up to a point. If you bring your credit utilization ratio below zero, credit bureaus can’t see any evidence that you’re using credit responsibly and that can potentially bring your credit score down. It’s a “use it or lose it” conundrum. So make sure to keep a couple of your credit accounts active. That’s reassuring to credit bureaus. The trick is to use some—but not too much—of your credit and make all of your payments on time.
● Credit bureaus reward consistency. You need to establish some kind of credit history before they’ll even assign you a score. Surprisingly, if you’ve always paid cash for your purchases, you may have a low credit score. The best thing you can do is apply for some kind of credit when you’re young: a gas credit card or store charge and/or an all-purpose Mastercard, Visa, or Discover card. Use your cards and make on-time payments. Maintain a very small balance so you can establish a favorable credit utilization ratio. Practice good credit behavior for a couple of years and you’ll be on your way to a higher credit score.
● Apply for new credit judiciously and very intermittently. In other words, don’t apply for a lot of credit cards all at once. Credit bureaus see that as a red flag—a sign you may be in financial trouble. Sure, it may be tempting to take advantage of bonus offers, such as retail card first purchase discounts. Don’t overdo it or your credit score will suffer. Too many hard credit inquiries on your report too quickly can cost you money in the long run.
● The mix of credit obligations you have plays a minor role in determining your credit score. It’s still worth noting, though. Having revolving credit plus an auto loan, for example, can work in your favor. Your credit mix accounts for about 10% of your credit evaluation.
A Few Other Tips for Homebuyers
So far we’ve looked at the factors that help determine your credit score. But while your credit score is very important to mortgage lenders, it’s not the only thing they look at before offering (or refusing you) a mortgage.
● Here’s a term you should get familiar with before applying for a mortgage: the debt-to-income (DT!) ratio. You can determine yours by adding up your monthly credit obligations, then dividing that figure by your monthly gross income. Or you can use an online calculator and let your computer do the math for you. Lenders prefer to see a DTI below 28% but you’re likely to be offered more favorable rates if yours is lower. If you can’t meet the 28% threshold, it’s a good idea to hold off on applying for a mortgage until you’ve paid down some of your debt.
● Make the largest down payment you can make on your home. The larger the down payment you make, the less risky you appear to lenders. They’re investing in your home and they want you to, as well. Some private lenders require you to put a minimum of 20% of your home’s value down before they will even consider your mortgage application. They will figure your loan-to-value ratio (LTV)—the amount of money you borrow compared to the value of your home. They’re most comfortable when that ratio is 80% or less. It’s certainly possible to put down less on a home, particularly if you apply for a VA or other government-guaranteed loan. But the interest rates you’ll be offered will be higher in either case. Plus, if you’re able to secure a private mortgage with a down payment of less than 20%, you may be required to pay for private mortgage insurance (PMI) until you have 20% equity in your home. Your mortgage payment may increase by more than 2% when you have to pay for PMI.
● Try to make one extra mortgage payment a year. You can accomplish this in one fell swoop, or by adding, say, an extra $50 to your monthly payment each month. The extra money you pay will lower your mortgage principal. The less money you owe, the less interest you will pay. and you’ll make smaller interest payments. You’ll also own your home free and clear sooner than you would if you just made the minimum payment on your loan.
● Shop around for the best homeowners’ insurance deal you can find. Investigate the policy discounts available to you. Bundling your homeowners’ insurance with your car insurance can reduce the amount you pay for both. If your home has a security system, you may pay lower premiums. As time goes by, ask your insurance agent whether you might qualify for a customer loyalty discount.
If you’re anxious to buy a home—perhaps your dream house was just listed for sale or your family is outgrowing your current home—it can be tough to take the time to improve your credit profile. But if your credit is subpar and you still take out a mortgage, you’re doing yourself a serious financial disservice. Wait until all financial factors are working in your favor. That way, you’re setting yourself up for greater financial security in the long run. And that should be top priority for every borrower.
Author Bio:
Susan Doktor is a journalist, business strategist, and small business owner. She covers a wide range of personal finance topics in her work, including the real estate and mortgage markets. Her contribution comes to us courtesy of Money.com.
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