Establishing good credit is crucial for optimizing the home-buying process. For most of us, accessing real estate hinges on having our credit in good standing. If you're willing to invest the time, do it diligently. Your real estate investment will shape your future for years to come, so it's worth prioritizing even small credit improvements.
In this article, we will guide you through a comprehensive evaluation of the necessary steps to improve your credit in preparation for purchasing a house.
Even if you have already exhausted your three complimentary credit reports for the year, it's advisable to obtain a recent copy of your credit before applying for a mortgage. Typically, your most recent credit report should not be more than three months old when you visit the bank. If there are delinquent items on your credit report, allow yourself at least six months to enhance your credit profile.
Make sure to carefully review and challenge any inaccuracies on your credit report. A strong credit history can lead to a lower interest rate, potentially saving you significant amounts of money over the course of a 30-year loan.
An important financial term that is often overlooked is the "tradeline." A tradeline simply means that you have an open line of credit that has been active within the past 1 to 2 years.
If you are looking for a loan from the Federal Housing Authority (FHA), you will need at least two open tradelines in your credit mix. Conventional loans typically necessitate having at least three tradelines. Financial institutions prefer to see multiple credit lines open to ensure your creditworthiness, especially when it comes to such a substantial investment like real estate.
If you have more tradelines on your record than the FHA or conventional lenders need, then you meet minimum requirements. This does not mean that you have optimized your credit. Take a look at your total credit limit (the total amount of money that your lines of credit say that you can borrow). Make sure that you are using no more than 30 percent of your allowable credit. If you are charging more than that percentage, pay it down or open a new line of credit until you meet the standard. Ideally, your record will show that you are paying off your credit bills in full every month.
If you have to open a new tradeline, do not do so with a retail store credit card account. This does not help with your qualification even if you pay it off in full every month. Ensure that your new tradelines come from a major credit card (one that has a Mastercard or Visa logo in the corner of the card). Paying off the line in full every month still applies here, so be vigilant.
Older lines of credit are worth more to mortgage lenders than new lines. The older your credit lines are, the more they improve your credit score.
For instance, if you have seven credit cards and you only use two of them, closing the other five will not necessarily raise your credit score. Remember that your total credit lines shrink every time you close down an account. If you close too many without paying off the rest, then your record may show you borrowing more than the 30 percent limit mentioned above. What's more, your unused accounts are considered good accounts by mortgage lenders. They may add to your credit score.
Older lines of credit help you the most, and new lines do not necessarily hurt you. But they can, so be careful about how you open them if your strategy includes expanding your credit with new tradelines. If you open too many cards, you can temporarily lead to bad credit. This is only temporary, so you may be able to strategize a better score if you have some lead time before you want to begin pursuing your bank loan. If you don't have more than 12 months, however, you may want to find an alternative to opening new lines of credit.
A better alternative is to use your older lines of credit more often and pay them off every month in full. Ideally, you are using those accounts once every two to three months. This will tag the accounts as "active" to mortgage lenders and keep them adding to your credit score.
Credit bureaus have no evidence to prove how you will handle new lines of credit. If you do not have six months to let your new tradelines become "old," you may be better off leaving them unopened. Under no circumstances should you use a retail credit card to implement any of these strategies.
If you start reducing your credit accounts to improve your financial standing, make it a priority and pay them off promptly. Make more than the minimum payment if you cannot pay off the loan in full on every account. If you have a history of minimum-only payments, you are not really given any informal credit by your home loan assessor. Your formal credit score will probably not go up, either. Why? Most commercial loans are structured so that the minimum payment does not begin to pay down the principal for some time.
Paying only the minimum amount means you're primarily covering the interest, which is not a sound financial approach, regardless of whether you're in the process of buying a home or not.
Use cash to purchase furniture or appliances for your home, waiting until you have the necessary funds available. Avoid any unexpected financial changes before closing to ensure your qualification remains secure.
Delay any plans to purchase a car on credit before closing on your home. This decision could jeopardize your home purchase, even if your lender indicates you qualify for the car loan. It's crucial to prioritize your home-buying process over any other credit commitments. Additionally, consider postponing any vacations financed through credit until after securing your home loan, as even small amounts borrowed could impact your eligibility for a mortgage.
Because there is a time factor in looking at your cash accounts to ensure the veracity of your banking records, moving money into an account to look more liquid than you are will not work. Your bank will ask you to provide several months of your payment history. If the bank sees that you have huge transfers into an account right before the home buy, they will investigate. They will uncover the transaction history and take appropriate action, potentially resulting in disqualification if funds were transferred into the account solely to impress the loan officer.
Once you have decided to buy a home, put an informal freeze on all of your accounts for at least three months. You can accept deposits and pay bills as you would normally, but do not make any "sudden financial moves" within this three-month period. In short, if you haven't done it before, don't start doing it now.
Not moving money around includes consolidating credit or shifting balances back and forth between your active credit cards. Engaging in such activities can reflect negatively on your financial credibility. Additionally, there may be accompanying flat fees each time you attempt this, which may not justify the potential benefits. Rest assured, loan officers or their systems are likely to trace these transactions. It's best to avoid attempting to deceive the system.
Regardless of the strategy you choose to improve your credit, it's important to remember that a great credit score and a history of good credit take time. Allow yourself at least six months to align all the necessary factors. Banks do not like to see any sudden financial moves in the months before you buy. Six months will give you time to pay down accounts, open new tradelines, and fix any errors on your credit report.
Getting great credit by having credit is the majority of the battle. However, the battle is not yet won. Having REALLY great credit means having some cash on hand. Your bank loan officer wants to see that you have the cash to EASILY cover the fixed costs of buying a home. The down payment is the most important metric here, but it is not the only one. Even if you qualify for a no down payment loan from the FHA, for example, you still need cash for other things (emergency account, furnishing the home, home insurance, etc.).
Ideally, the bank wants to see that you have at least 20 percent of the price of the home in cash as a down payment. This down payment gives you equity in the home and shows the bank that you share the risk of the mortgage with the bank. If you do not have 20 percent, you may be on the hook for expensive Private Mortgage Insurance (PMI). PMI is an extra cash payment that your bank may demand of you to reduce its risk profile if you do not have the cash for an appropriate amount of equity.
Do not be swayed by misinformation - it is essential to schedule a home inspection and budget for an independent audit of the desired property. Your bank will not require this of you in most cases. However, it is just good business. If you buy a home without inspecting it, you may very well have to sell it at a loss or spend good money repairing it. Neither option will be good for your credit down the line.
The cash you have also helps create your borrowing profile. Ideally, the monthly mortgage payment you take on should be no more than 30 percent of your monthly income. Your bank may use this metric as a benchmark to help decide your home loan fate. All else being equal, meeting this metric will help you qualify. 30 percent is also a well-tested benchmark that you should personally trust. If you spend more than 30 percent of your income on your mortgage, then you may not have enough money for the fixed costs associated with owning a home (unexpected repairs, scheduled maintenance, etc.).
Look at the pre-qualification process as a free mentorship program from the bank. It is a dry run of the real thing - you will have to turn in all of your paperwork, and you will receive a response from the bank. However, you do not have to go through a real credit check (which lowers your credit score), and nothing goes on your permanent record if you "fail" the test.
Get together your paperwork and follow the steps above to improve your credit as much as possible. Go through the pre-qualification process. Your bank will tell you, without dinging your credit, the mortgage amount that you are likely to qualify for. Once you have this number, you can begin thinking about how to improve your scores to meet the number that you want. If the number looks good, then you can confidently move forward with the mortgage process.
Getting an inspection from a dispassionate third party may help your credit indirectly. If the inspector finds a considerable issue, you may be able to negotiate the sell price with the seller. If you get the price lower, your down payment requirements go down. Your closing costs may go down. If the changes are significant enough, you may qualify for a home loan when you would have otherwise been disqualified.
By implementing these best practices, you could potentially save a significant amount of money over the duration of your next mortgage. Great credit not only benefits you financially but also opens up other opportunities. Stay motivated, as the benefits of your diligence will far surpass the hard work you put in now.
Credit is one of the best investments you can make in yourself. Make that investment now so that you can benefit down the road in many ways, including buying the house of your dreams.
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Topics: Home Ownership, Credit Management
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