Why Debt Matters
Your credit score is like an adult report card. Except instead of showing off your ability as a student, it demonstrates how good of a borrower you are.
When lending money, the bank’s primary concern is determining whether or not you will pay them back. In consideration of something like a $500,000 mortgage to buy a home, the lending institution is taking on a lot of risk should the loan not be repaid.
To determine how trustworthy a potential borrower is, the bank will examine their credit history.
Credit Scores Are Just Part of the Pie?
Credit scores aren’t the only factor that lenders consider when reviewing a mortgage application. They will also require information on your employment, income, and bank accounts. A lender facing someone with a low credit score may increase expectations in other areas like size of the down payment or income requirements.
The lowest credit scores that lenders are willing to accept change with the economic environment. During the housing crisis of 2008 and the years after, it was very difficult for borrowers with credit scores lower than 700 to obtain loans.
During better economic times, credit score requirements for borrowers may loosen. Therefore, it is a bit of a moving target to nail down the precise average or the lowest possible credit score one must have to receive a mortgage loan.
How To Bump Up a Credit Score
Working to improve a credit score before applying for a home loan could save a borrower a lot of money in interest over time. Lower rates will keep monthly payments lower or even provide the ability to pay back the loan faster.
Let’s look at an example using a mortgage calculator: If you were take out a mortgage on a $400,000 home after putting 10% down with a 4.5% interest rate on a 30-year fixed rate mortgage, your monthly payment would be $1,824 and you would pay $296,663 total in interest over the life of the loan.
If you were to take out that same loan with a 5.5% rate of interest, your monthly payment would be $2,044 and you’d pay $375,854 total in interest. The difference of 1% in interest results in almost $80,000 paid over time.
Improving your credit score will take a bit of time, but it can be done. Here’s how:
1. Check for errors on your credit report. Reporting errors are quite common, so be certain that your credit history doesn’t mistake a missed payment or report a debt that’s not yours. You can get a free credit report once a year from each of the three reporting agencies: Transunion, Experian, and Equifax.
2. Pay all of your bills on time. If you haven’t been doing so, it could take up to six months of on-time payments to see a significant improvement.
3. If you do not have credit established, an easy way to do so is by opening a credit card. But only do this if you are prepared to use the credit card responsibly. This means paying back the card, in full, each month. Do not simply pay the minimum payments. If you are having trouble qualifying for a card, look into a secured credit card. With a secured card, you put a cash payment down that works as your line of credit, proving you can manage a credit card.
4. Request to increase the credit limit on one or all of your credit cards. This will increase your credit utilization ratio by showing that you have lots of available credit that you don’t use. It is best to keep the credit utilization ratio below 30%, meaning you’re only using 30% of your available credit at any time.
Understand that this number can be assessed at any time during the month, not just on the day that you pay your bills. Even if you pay your cards in full every month, if you’re consistently using more than 30% of your available limit, you could get dinged.
5. If you are working to pay off credit cards, don’t close them once you’ve paid them off. Keep them open by charging a few items to the cards every month (and paying them back). Remember, sources of debt that have been in use for longer are preferable to ones that are new. For example, if you have two credit cards, each has a credit limit of $5,000, and you have a $2,000 balance on each, you currently have a 40% credit utilization ratio. If you were to pay one of the two cards off and keep it open, your credit utilization would drop to 20%.
6. Consider obtaining a personal loan. If you have multiple credit cards and are struggling to manage them and pay them off, this might be a good solution. A personal loan may have a lower rate.
Another option for those with lower credit scores is to have a cosigner on a mortgage loan. If this person has a better credit score and financial situation than the main applicant, it could greatly improve the rate that a lender will offer. Only go down this route if this is a relationship that you can trust completely.
Once you feel that your credit score is ready, be sure to shop around for a home loan at several lenders. You want to be sure that you’re getting the best rate given your personal financial situation, and not every lender has the same criteria.
Know that even with credit scores that aren’t perfect, there are options for people who want to be homeowners; it’s just a matter of seeking out those options.
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