If you need a loan, whether to buy a new home or refinance an existing property, you need to understand your credit and its impact on what a lender is looking for. This is especially the case in today’s market, where qualifying for a mortgage is not as easy as it was just a few short years ago.
You credit score* is used to determine how much of a credit risk you are. Do you fit a profile that shows to pay back the loan? Do you have collections accounts outstanding or account delinquencies? Is your credit score high enough to qualify for the loan program you are seeking? Your credit score and the information presented in your credit report help to answer these important questions, which goes a long way in determining whether or not a lender will lend you the funds you need for your home loan.
Here are the areas lenders take into consideration:
1. Credit History
Lenders want to see a consistent track record for paying back your debts. The longer and more consistent the track record, the better. On the other hand, your credit score will decline if you've had any of the following: bankruptcy, foreclosures, collections, judgments, defaults, liens (all are indications that you've either not payed a creditor money owed them). If a lender sees this, they will assume you are a higher risk for defaulting which will make it less likely they will be willing to lend to you.
2. Your Debts
The Debt-To-Income (DTI) ratio is a ratio lenders use to calculate how much you owe for monthly debt obligations vs. how much you earn in monthly income (after tax). Typically, this ratio should be no more than 45% (for a Fannie Mae approved loan). For example, if your monthly after-tax earnings are $5,000, then the amount you spend on monthly debt should be no more than $2,000 (including your monthly mortgage payment, property taxes, and homeowner’s insurance).
3. Payment Track Record
Do you pay your bills on time? Do you pay regularly? Your credit report will indicate the length and quantity of any delinquencies that are reported by your creditors. Just one missed credit card payment can lower your score - so make sure you're paying your bills on time!
4. New Account Activity
Any activity in which you're trying to obtain a new line of credit (i.e. an auto loan, credit card, etc.) is reported and captured on your credit report. Even if you aren't approved or choose not to use it - opening a new credit account can lower your credit score. So don't apply for every credit card deal you see - you may be harming your credit score. If you are in the middle of obtaining a loan from a lender, you should avoid opening any new accounts while your loan application is being processed, as any new accounts that you open could negatively affect your qualification by raising your DTI or reducing your credit score.
5. Variety of Credit
Lenders want to see that you've had a variety of credit - it helps round out your credit background. But not all credit is equal. For example your payment history on a mortgage payment has more weight than your history payment on a credit card.
Rules of thumb:
- Don't bite off more than you can chew: Be aware of how much credit you're using in relation to your income. Also, don't apply for a lot of credit, especially if you don't have a good reason to.
- Pay on time! While this might sound overly simplified, one late payment could negatively affect your credit score.
- You may need to establish more credit history. If you don't have variety in your credit, ask a professional (your mortgage broker or loan officer) for tips on ways to improve your credit history.
Remember, for a home loan: Good credit = Good rates!
*A statistically derived numeric expression of a person's creditworthiness that is used by lenders to access the likelihood that a person will repay his or her debts. {Source: Investopedia.com}
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