Look, we’re not going to sugar coat it: your credit score is important if you want to buy a home. That 3-digit number carries a pretty big weight in the mortgage process. It’s used to help determine your rate, not to mention your eligibility for a home loan in the first place.
The good news is: you don’t need a perfect credit score to buy a home. But you should work to improve your score as much as possible if you want to get the best deal on your mortgage.
Why is your credit score so important?
Before we dive into how to improve your score, it’s probably a good idea to cover why your credit score is so important for home buying.
So, here’s the deal: Your credit score is generally tracked by companies called “credit bureaus.” The three major credit bureaus (those you’ll find on most credit reports) are Experian, TransUnion and Equifax. Credit scores range from 300 to 850 and provide an overall measure of your track record for managing and paying off debts. The debts affecting your credit score can include credit cards, car loans, student loans, medical bills, and personal loans, among others. A strong credit score — typically anything 700 or over — shows that you pay your bills on time each month, and that you’re unlikely to default on your payments. This is music to a lender’s ears because ultimately, they’re taking on financial risk to loan you money. Especially when you’re talking about a home loan that’s hundreds of thousands of dollars.
That’s why it’s crucial to get your credit score up as high as you possibly can before applying for a mortgage (and you’ll need to keep it there throughout the lending process). You want to show your lender that you’ll be an upstanding borrower, and that you can be counted on to pay off your debts. Aside from appealing to lenders, a good credit score will get you a better rate on your mortgage, saving you thousands over the life of your loan. Typically, the lowest mortgage rates are available to borrowers with credit scores of 740 or higher.
Meanwhile, a lower credit score will result in a higher mortgage rate, which unfortunately means you’ll pay more for your home over time. Not only that, but a lower score will likely require you to make a bigger down payment on your new home.
What makes up your credit score?
Okay, you know your credit score is important. But do you really know what’s packed in there? Few of us really ever consider how our scores are calculated, but it’s crucial to understand how the sausage gets made if you want to make improvements.
No credit bureau is going to tell you precisely how they calculate your credit score, but according to Experian, the calculation breaks down something like this:
Payment history: 35% of your score
What goes into it: This portion of your credit score reflects—you guessed it—your payment history. If you pay your debts on time each month and cover at least the minimum payment amount, this portion of your score should be in relatively good shape.
Utilization: 30% of your score
What goes into it: Utilization is how much credit you’re currently using versus how much you have available. For the most part, the less credit you’re currently utilizing, the better your credit score. For example, say your credit card has a maximum balance of $10,000. If your balance is relatively low, say $1,000, this will reflect better on your credit score than if you were using up $8,000 of your maximum credit.
Length of credit history: 15% of your score
What goes into it: Creditors want to see that you have a solid long-term history of paying off debt. Think about it: a lender can’t tell very much about whether you’ll pay your mortgage on time from looking at 3 months of data. So, the longer your history with credit, the better.
Mix of credit: 10% of your score
What goes into it: Interestingly, having different types of debt is considered a good thing by the credit bureaus. It shows that you can handle different types of loans (car loans, student loans, credit cards, etc.), and that you’ll pay them back according to the terms of your contracts.
New credit: 10% of your score
What goes into it: Opening a new line of credit can negatively impact your score for a while. That’s why you should avoid taking out any new loans in the months leading up to your mortgage. Remember — the credit bureaus reward you for longer-term credit. Be very careful about adding any new debt while you’re home shopping.
Make sure to keep these elements in mind as you work to improve your credit score. They can help guide you on where to prioritize your time (and money!).
What can I do to help my credit?
Now that you’ve got a basic understanding of what goes into that magic number called your credit score, we’ve rounded up the top 6 need-to-know tips to get you financially fit for home buying.
- Check your credit reports
The first step to improving your credit? Knowing what you’re up against. That means pulling your credit reports from all three major bureaus and going through each one with a fine-tooth comb. Keep in mind that you’re entitled to pull your credit report from each of the three major credit bureaus for free once per year. Use them! You can get your free credit reports at Annual Credit Report, a government-run site.
Skip estimator tools
Of course, you can always get a free estimated credit score from companies like Credit Karma. But it’s best to see your official credit reports from the big three credit bureaus. This is what your mortgage lender will reference, so you should too.
Credit score estimators, while great tools, can be off-base. We’ve seen it way too many times: a homebuyer will apply for a mortgage based off a score they found on a credit score estimator tool, and then learn the hard way—after applying for a mortgage—that their true score was lower. Don’t let this happen to you! By working from your official credit reports, you’ll go into the mortgage process with eyes wide open.
- Identify and fix issues with your credit reports
Now that you’ve got your credit reports handy, you can focus on fixing the items that are bringing your score down. Go through each of your three reports line by line. Verify that all the information is correct, and highlight any accounts or line items that are negative or inaccurate. These are your areas for improvement.
Always dispute credit report errors
Did you know that credit report errors are extremely common? According to recent government data, more than 1 in 5 Americans have material (read: pretty major) errors on their credit reports.
Credit report errors can affect your ability to get a mortgage, and can hurt your rate too. The good news is, you have recourse. Every consumer is entitled to dispute an error on their credit report. And both creditors and credit reporting agencies are required by law to correct your report if an error is found.
How to dispute an error on your credit report
If you see an error on your report, you should dispute it as soon as possible. To do this, send a dispute letter to the credit bureau that made the error requesting that it be removed (the government put together a handy dispute letter template you can use). Include any supporting documentation proving the error was made. By law, the credit bureaus are required to investigate an error within 30 days, and remove the error if the creditor can’t verify the accuracy of the disputed item.
They’re also required to send you the results of the investigation, plus a copy of your credit report if a change has been made. You should also send a dispute letter to the creditor who made the error, providing the same supporting documentation you sent to the three credit bureaus.
One caveat: When you dispute an error on your credit report, the credit bureaus will list the account as “disputed” on your reports. This dispute is visible to anyone who views your credit report. If you’re disputing an account at the same time as you’re applying for mortgages, you could experience financing delays. Most mortgage lenders won’t clear your loan until disputed accounts are resolved. This is another reason to give yourself adequate time to repair your credit before applying for a mortgage.
- Settle outstanding debts in collection
If you have outstanding debts that have gone into collections, they could be bringing your score down significantly. Now is the time to settle them. Call the collection agency and tell them you want to “pay to delete” the debt. What this means is that you’ll pay what you owe on the account and they’ll delete the negative item from your credit report.
Be sure to write down all the information from your call; who you spoke with and their contact information, plus note any negotiations you came to. Finally, make sure you get a “pay for delete” letter from the agency confirming you paid the balance and the agency will remove the debt from your credit report. You can use this as proof to the credit bureaus if for some reason the negative account remains on your credit reports.
Pro tip: You can often negotiate the amount you owe to a collector, but always confirm that they will in fact delete the negative account from your credit reports before coming to an agreement.
- Pay down your balances
Remember how credit utilization accounts for a whopping 30% of your credit score? One way to quickly improve your credit is to lower your utilization. That means paying down your debts.
Have a balance on your credit card you’ve been meaning to pay off? Now’s the time! The lower you can get your utilization leading up to taking out a mortgage, the better. Experts suggest keeping your utilization below 30% to protect your credit score. In other words, you should be using less than 30% of your available credit. Think of this step as freeing up room in your financial profile for your home loan. The good news is, this tactic can improve your score dramatically and quickly.
- Avoid taking on further debt
During the period when you’re preparing to buy a home, and even while you’re going through the process of taking out a mortgage, it’s imperative that you avoid taking on any further debt. Opening up new debt accounts (for example: taking out a car loan) will negatively impact your credit score. So it’s important to wait until after you’ve closed on your home to consider taking on a new loan.
Pro tip: Even if you’ve already applied for a mortgage and been approved by your lender, you could jeopardize your home loan if you take on additional debt before the deal is closed. Mortgage lenders monitor your credit throughout the entire lending process, which takes an average of 45 days nationally to complete. Any changes could delay or even upend your financing.
- Don’t close any accounts
Finally, it’s best not to close any credit accounts while you’re applying for a mortgage. There is a lot of debate over whether closing unused accounts hurts your credit. But given the fact that your score partly looks at your mix of credit and length of credit history, it’s probably best not to mess with anything so close to taking out a home loan.
Keeping the account open but inactive shouldn’t hurt your credit, but closing an account so close to applying for a mortgage might cause concern on the lender’s part. If you really want to shutter the account, wait until after you’ve closed on your new home.
Give yourself time
It’s ideal to start the process of going through and repairing your credit well before you’ll be applying for a mortgage. Give yourself at least three to six months for minor credit repair. If you have significant credit issues, you’ll likely need at least a year to see significant changes.
The truth is, improving your credit score takes some time. It can be weeks, or even months, for your score to reflect any positive changes you make. Don’t expect that you can repair your credit overnight. Give yourself adequate time to complete this important step in the homebuying process.
Credit To: Chelsea Levinson and homelight.com