The journey toward homeownership starts with a good look at your credit score. This is one of the main pieces of information that lenders review before approving you for a mortgage. Based on your credit, lenders will offer an interest rate and determine down payment requirements for your home loan. In the eyes of a mortgage company, a strong credit history makes you a trustworthy borrower. The higher your credit score, the lower your interest rate will be.
As you prepare to apply for a home loan, it's important to review your credit report well ahead of time. This will help you determine if you need to improve your score. And while there is no quick fix to clean up your credit, there are some steps you can take to improve your credit score and increase your chances of being approved for a home loan.
1. Check your credit reports
Knowledge is power and reviewing your credit report is the first step in finding any information that's negatively affecting your score. Run your report with the three major bureaus and use the information to understand and manage your credit. With this knowledge in hand, you can figure out the next steps to boost or maintain your credit before applying for a home loan.
If you find any errors in your report, you must notify the proper bureaus and creditors as soon as possible. When filing disputes, be sure to include all required documentation and send your letters via certified mail.
Once the errors are corrected, contact the credit bureau to have these accounts removed as disputed. Lenders require disputes be resolved before you apply for a mortgage to make sure your credit score is accurate when you apply.
2. Monitor your credit score
Your credit score is an important part of your credit report. This three-digit number is key to your lender's decision and helps determine the interest rate offer you'll receive. If your score is lower than you would like, be sure to thoroughly review the analysis included in your report. This information provides insight into how you can start working toward a higher score.
These are the five main categories that determine your credit score, according to FICO:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Types of credit used: 10%
3. Pay off delinquent accounts
Payment history represents the greatest percentage of your credit score (35%). If you currently have any delinquent accounts, bring them current or paying them off before submitting a mortgage application can make the difference between approval and denial.
Delinquencies include any past due payments, charge-offs, collections or judgments that may be in your report. A delinquent-free report lets mortgage lenders know you're a responsible borrower.
4. Make payments on time
When reviewing your application, lenders will look for consistency in your financial behaviors. Because they're looking at historical information, there are no shortcuts to establishing a solid pattern of timely payments. Therefore, every payment you make on time is important. It's a step toward improving your credit history and brings you a little bit closer to your dream home.
It takes some time to build your credit score back up after delinquencies and late payments. If you have these in your report, it's a good idea to keep your accounts current for several months before applying for a mortgage.
While multiple months of consistent payments will help make delinquencies less damaging to your report, keep in mind that they won't disappear quickly:
- Delinquencies remain on your credit report for 7 years.
- Bankruptcies typically stay on your credit report for 7 years.
- Inquiries appear on your report for 2 years.
5. Avoid new debt
Because inquiries also affect your credit report, it's a good idea to avoid applying for new loans when you're trying to improve your score.
Additionally, new debt often raises a red flag to lenders. They interpret it as a sign of financial instability and possible lack of responsibility. Established long-time credit is critical in your application. This is a crucial factor that shows the responsibility and reliability lenders look for.
6. Keep low balances
Debt-to-income ratio (DTI) is the percentage of your monthly income that goes toward paying off debts. If you make $10,000 in pre-tax income a month and owe $4,000 in monthly payments towards outstanding loans, your DTI is 40% (40% of your income goes towards paying debt).
Mortgage lenders prefer borrowers with low DTI ratios. This shows you're more likely to be able to afford your monthly loan payments.
In addition to your current DTI, lenders also look at how a home loan could affect your ratio. Once approved, a home loan should not increase your DTI to an unnecessarily high ratio. This rule of thumb helps keep your personal finances under control, and it's a good way for lenders to ensure you can keep up with your monthly home payments.
7. Pay down your balances
To the greatest extent possible, you want to treat all your debt as a monthly bill. Paying off your revolving loans every month is a good financial habit that has a positive effect on your credit score. It does wonders for your payment history and also lowers the total amount owed.
One way to boost your credit score is to lower your balances to 30% of your credit limit.
8. Keep your accounts open
While it's tempting to close your accounts once balances are paid off, this isn't always the best idea. When lenders review your application, they look at the amount of open credit vs credit used. This is known as your credit utilization ratio.
Closing accounts lowers your total amount of available credit and increases the percentage of credit in use. A higher credit utilization ratio can also have a negative impact on your score.
Lenders prefer lower utilization ratios because they show financial stability and self-discipline. Borrowers who have credit available but don't use it all or pay it off every month appear more credible to lenders.
9. Know how much you can afford to borrow
When you have a monthly budget, it's easy to know exactly how much you can afford to pay every month. Understanding your personal finances and being in control of your cash flow is essential when taking out a loan. It helps you avoid getting into debt that you can't pay off, which could potentially harm your credit.
If you know the monthly dollar amount that's manageable for your personal budget, the chances of missing or struggling with payments are lower. When taking out a home loan, choose a house that you can comfortably afford so you can enjoy the benefits of homeownership without the additional stress.
Building good credit takes time
Building good credit is a gradual process. While it takes time for negative information to disappear from your credit report, there are a number of steps you can take now to start improving your credit score.
As you work toward your goal, focus on what can have a positive effect rather than what is causing a negative impact in your credit report. Be sure to continue in that direction and stick with making good financial decisions. Our tools are here to help you understand the ins and outs of credit reporting and guide you towards homeownership.
