If you’re eager to move into your dream home, preparing your credit for a mortgage approval should definitely be on your agenda. It’s a key factor for getting the best, low-rate loan for your new home.
But building credit doesn’t happen overnight—early preparation is critical. In this post I’ll give you 6 tips for building credit before you apply for a mortgage, so you get a loan that costs as little as possible.
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Benefits of a Getting a Low-Rate Mortgage
No matter if you’re a seasoned homeowner or are looking for your first property, improving your credit scores ahead of a mortgage application can pay off big time.
Here’s an example: Let’s say you get a $250,000 fixed-rate mortgage for 30 years at 4% interest. Your monthly payment for principal and interest will be about $1,200. But if you get the same mortgage for just 3% interest, you’d pay close to $1,000, saving nearly $200 per month.
If you keep that loan for the full 30-year term, paying just 1% less in interest would allow you to save $50,000, instead of needlessly paying it to your lender!
See Also: 7 Credit Score Traps to Avoid
6 Tips to Prepare Your Credit for a Mortgage Approval
Before you pull the trigger on a mortgage application, use these six tips to prepare and build your credit scores:
Tip #1: Check your credit reports
When you’re shopping for a mortgage, lenders review your entire credit reports(s), not just your credit scores. So the first step to getting a great home loan is to get familiar with what’s currently on your credit reports with the 3 nationwide credit bureaus: Equifax, Experian, and TransUnion. Always know know what’s in your credit history before a potential lender does.
Federal law requires the big bureaus to give you a free credit report every 12 months if you request it. You can get reports from each of the bureau websites or access all of them at Annualcreditreport.com.
Your credit scores are based entirely on the information in your credit reports, such as your account balances; payment history; and legal information like liens, judgments, and bankruptcies in your past. That’s why it’s so important to make sure your credit reports are correct.
You probably won’t know which of your credit report(s) a mortgage lender will examine and they could they look at all of them. So I recommend that you review all 3, especially if you’ve never pulled them or it’s been a while.
One piece of information that you won’t see in your credit reports is your credit score, which you typically have to pay for. However, I’ll mention some terrific resources to get free credit scores in just a moment.
See also: Best Tips to Improve Your Credit Score
Tip #2: Correct credit report errors quickly
When you view or download your credit reports, check them for errors very carefully. Look for accounts that are not yours, incorrect account balances, misapplied late payments, or anything else you simply don’t recognize.
If you see a mistake, report it immediately. Credit investigations can take up to 45 days, so the earlier you submit a dispute the better. Each bureau is required to automatically notify the other 2 about disputes, so you only need to submit it once.
If you have old debt in collections, that’s a huge red flag to potential home lenders. They may deny your mortgage application altogether or quote you a high interest rate.
Consider paying off any past due balances or negotiating a settlement with your creditors. Arranging a lump sum payment or a monthly payment agreement won’t remove bad debt from your credit report, but it does help clean it up.
Even after you pay off a credit account, it stays on credit report for many years. Debts with positive payment history stay in your file for 10 years and those with negative information remain for 7 years after the date you originally became delinquent.
Even though debt in collections causes your credit scores to plummet, it can be overshadowed by newer, positive information over time. In other words, rebuilding your credit is a long-term endeavor and you may need to wait for your scores to rebound before buying a home if you want the best rate and terms.
See also: The Statute of Limitations and 4 Options for Old Debt
Tip #3: Understand what credit scores lenders want to see
When a mortgage lender orders your credit report, they can also purchase different types of credit scores. Scores help lenders summarize data in your credit report and easily evaluate the risk of doing business with you.
There are hundreds of different credit scoring models created by the credit bureaus and other companies. Two popular products for mortgage underwriting are FICO and VantageScore.
Each type of credit score uses a different score range and evaluates you differently.
Home buyers with a FICO score of 740 or above usually qualify for the best rates—but there’s no cutoff score or hard line used by all lenders.
For instance, the FICO score ranges from 300 to 850 and is calculated on these criteria and percentages:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit requests: 10%
- Types of credit accounts: 10%
Here’s what FICO scores mean to lenders:
- 300 to 579: a very risky borrower
- 580 to 669: a somewhat risky borrower
- 670 to 739: an average to low risk borrower
- 740 to 799: a dependable borrower
- 800 to 850: an exceptional borrower
Home buyers with a FICO score of 740 or above usually qualify for the best rates—but there’s no cutoff score or hard line used by all lenders. Plus, there are additional factors used to determine your interest rate and loan terms, such as your income, job stability, and total debt.
An increasing number of companies, services, and apps are hopping on the “free credit score” bandwagon:
- Credit Karma offers free credit reports and scores from TransUnion and Equifax
- Credit Sesame offers free credit reports and scores from TransUnion
- Quizzle offers free credit report from TransUnion and a free VantageScore credit score
Additionally, credit card issuers such as American Express, Chase, Citi, Discover, and Bank of America offer FICO or other types of scores for free with certain products. Find out which score(s) your preferred lenders use and get yours. Even if you have to pay $30 or $40 for it, it’s worthwhile to understand how you can improve your credit health ahead of a mortgage application.
See also: FICO vs. VantageScore Credit Score--What's the Big Difference?
Tip #4: Reduce your credit utilization
Canceling an account could significantly reduce your available credit, which would cause your credit utilization to skyrocket and your scores to go down.
I mentioned that your payment history is one of the most important factors in the calculation of your FICO credit score. Paying your credit obligations on time is a powerful way to boost your credit, so never let any bill slip through the cracks—especially when a mortgage may be in your future.
After payment history, your credit utilization is the next essential factor to watch. This is the percentage of your available credit in use.
For example, if your credit card has a $10,000 line of credit and you have a $5,000 balance, your utilization is 50%. The optimal credit utilization is about 20% or less. So paying the balance down to $2,000 would result in quick boost to your credit scores.
Another important strategy is to avoid closing any credit accounts before getting a mortgage. While it might seem like having fewer accounts would make you appear more attractive to a lender, it can actually work against you.
Canceling an account could significantly reduce your available credit, which would cause your credit utilization to skyrocket and your scores to go down. So play it safe and wait until after you move into your new home to close unwanted accounts.
Also, having a mix of revolving accounts—like credit cards and lines of credit—and installment loans (such as auto, personal, or student loans) helps your credit. If you close all your credit cards, that could negatively affect your scores. To have the highest scores you need to have both types of accounts with positive payment history.
Remember that even a small drop in your credit scores could put you in a lower bracket that results in a higher interest rate, costing you tens of thousands of additional dollars over the life of your mortgage.
See also: How Many Credit Cards Should You Have for Good Credit?
Tip #5: Cut your debt-to-income ratio
Having great credit won’t get you approved for a mortgage if your debt is out of control. Lenders use a formula called your debt-to-income ratio or DTI, which shows how your housing expenses and your total monthly debt obligations stack up against how much you earn.
The housing, or front-end, ratio shows what percentage of your income would go toward your expenses such as a monthly mortgage payment, property taxes, association dues, and home insurance.
The total, or back-end, ratio shows what percentage of your income would go toward all your debts, like a mortgage, car loan, student loan, and credit cards. For example, if your all your monthly obligations total $25,000 and you earn $50,000, your back-end DTI is 50% ($25,000 / $50,000 = 0.5 = 50%).
Common DTI thresholds are 25% to 28% for housing and 36% for total debts. If you exceed these, you may need to pay down some debt in order to get approved for a mortgage or to reduce your interest rate.
However, depending on variables like your credit score, down payment, and type of loan, you may get approved with higher ratios.
Tip #6: Shop strategically for a mortgage
The last tip is to carefully plan when you’ll apply for and shop different mortgage lenders. Applying for a new credit account is called a hard inquiry and it dings your scores. However, a cluster of similar applications completed within a short period of time, such as 2 to 3 weeks, won’t hurt as much.
Credit scoring models recognize typical shopping behavior and won’t penalize you for comparing offers. So come up with a list of lenders you want to shop and apply for multiple loans quickly.
Also, this not the time to shop for a new car, open retail store cards, or new credit cards. Wait until after you’ve moved into your new home to make any new credit requests so they don’t spoil your mortgage terms.
Remember that every credit score point counts! Use these tips as far in advance of buying a home as possible to avoid getting turned down for a mortgage or paying more than you should.
For more tips on how to review, repair, and build your credit, check out my free Credit Score Survival Kit. It’s a multimedia tutorial that includes a video, audio, and e-book that teaches you 3 smart and legitimate strategies to build excellent credit.
See also: How to Get Credit With No or Bad Credit
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