What to know about credit before buying a home

What to know about your credit before buying a home

Buying a house is exciting, but it’s also one of the biggest financial decisions you’ll ever make. Thus, it takes careful planning and preparations. One of the best ways you can prepare for buying a home is by monitoring your credit score.

Your credit score influences many facets of your financial life, so it’s important to keep an eye on it. The moment you consider buying a house—even if it’s years beforehand—you should check your score. Your credit score will determine the loan you’re eligible for and how much you will pay in the long run.

To help you prepare for home buying, we’ve gathered some need-to-know information on credit scores and how it can influence your mortgage.

Understanding the Basics

Take some time to understand the basics of a credit score. A credit score is a number between 300-850 that determines how worthy you are of borrowing money. The higher the score, the better you look to lenders.

Imagine this: Your friend wants to borrow money from you. When they have borrowed from you in the past, they have paid you back on time and in full. So, you are more likely to let them borrow money again. But if they were late and didn’t pay you back the full amount, then you may be less likely to let them borrow next time or you’ll put conditions around the loan.

In other words, the higher the credit score, the better loan you’re going to get. A higher score means lower interest rates and more money saved. So, what’s a good credit score? The answer is that it varies depending on the model. Here is the popular score ranged from FICO:

  • Very poor: 300 to 579
  • Fair: 580 to 669
  • Good: 670 to 739
  • Very good: 740 to 799
  • Exceptional: 800 to 850

How Your Credit is Calculated

Your credit score is based on pieces of information found in your credit report. FICO, for example, uses five categories to determine your credit score:

  • Payment history (35%): How well did you pay past loans?
  • Amounts owed (30%): Do you currently have loans that you owe?
  • Length of credit history (15%): How long is your credit history? The longer, the better.
  • New credit (10%): What recent credits have you opened recently?
  • Credit mix (10%): What are the different types of loans you’ve managed?

Your credit score reflects both positive and negative information. It is possible to establish and re-establish your credit score. To improve your score, Investopedia suggests steps such as reviewing your credit report to find areas of improvement, working on paying your bills on time, paying off your credit cards in full each month, and limiting your hard and soft credit inquiries.

Why Your Credit is Important in Home Buying

You don’t need a perfect credit score in order to take out a mortgage loan. Many lenders have a base score they accept, potentially as low as 500. However, the better your credit score, the better options you'll have for your mortgage loan.

According to NerdWallet, a loan insured by the Federal Housing Administration (FHA) will allow down payments as low as 3.5% for those with a credit score at 580 or above. If you have a score between 500 to 579, you will be required to make a 10% down payment. The lender can also impose their own credit minimums based on your score. A loan by the U.S. Department of Agriculture (USDA) doesn’t have a set credit score. Instead, lenders set their own minimum. However, a credit score above 640 could make you eligible for streamlined credit processing through the USDA.

Ultimately, two people can get approved for a loan but there can be major differences. Imagine Person A pays her credit cards in full and never misses a payment. They have a strong 10-year credit history and get approved for a loan with 3.75% interest rate. Person B, on the other hand, is still paying off college loans, doesn’t track bills, and is consistently late on payments. He gets approved for the same loan but with 5.5% interest rate. They both got approved but the difference in interest rates could cause Person B to pay $75,000 across their lifetime.

The bottom line is that your credit score is more than just a number. It has an incredible impact on your entire financial situation. Monitoring and managing your score is vital in the home buying process and beyond.

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