The Home Buyer's Guide to Credit
A tutorial on credit reports and credit scores, created specifically for home buyers. Brought to you by the Credit Center at HomeBuyingInstitute.com.
In this guide, we will eventually discuss the strong connection between credit and home buying. We will also talk about what constitutes a good credit score, and how you can maintain one. But let's start with the basics by defining what credit is in the first place.
What is Credit?
In home buying and mortgage terms, "credit" usually refers to your credit score (which, in turn, is derived from your credit history). Your credit score is a numerical "grade" between 300 and 850. The higher the score, the better. This credit score is based on your credit report, which is basically your credit history on paper.
To state it more simply:
You credit history [leads to] Your credit report [leads to] Your credit score
Credit makes the financial world go around. If our economy were not based on credit, we would have to pay for everything up front. Fortunately, this is not the case, and we are able to buy things on credit. We can take out loans for major purchases and pay the amount back over time.
When we as consumers apply for a loan (such as a home buyer applying for a mortgage loan), we get approved or disapproved for that loan based on our "creditworthiness" — a financial term that refers to a person's trustworthiness with money as based on their credit history. Thus the connection between home buying and credit history, which we will talk about next.
Credit & Home Buying
For most people, buying a home means taking out a mortgage loan to pay for the home. Unless, of course, you've just won the lottery, inherited a fortune from Uncle Ernie, or invested in Apple Computers stock back in the 1980's.
To obtain a mortgage loan, you must have a credit history behind you — and ideally a good one. Mortgage lenders need to review your credit history in order to approve you for a loan. If your credit is good, you'll have an easier time getting a loan. If your credit is bad, you will have a harder time obtaining a mortgage loan. The two things are directly relational.
Early on in the home buying process, you should review your credit situation. That way, if you need to improve your credit score, you can start right away.
Your Credit Report
Credit reports are maintained by three credit-reporting agencies: TransUnion, Experian and Equifax. These companies maintain any and all information pertaining to your personal credit — payment habits (including late payments), level of debt, any bankruptcy or other financial issues, etc.
As a home buyer, one of the first things you should do is request copies of your credit reports (all three of them) to review the reports for errors. It's not uncommon for erroneous information to appear on one's credit report. So get copies of yours and check them for accuracy.
Make sure your name and other personal data are correct. More importantly, check for any credit activity that is not yours, such as a loan or a line of credit you did not take out. This could be a simple computer error, or it could be a sign of credit fraud.
Your Free Credit Reports
You are entitled to one free credit report (from each company) per year. So if you've never requested your credit report before, you have a "freebie" awaiting you. There are many ways to request your reports online — so many, in fact, that it can be overwhelming and confusing. So let's clear things up...
No matter where you go online to request your credit reports, the information always comes from the same place (the three credit-reporting companies). Many websites offer free credit reports, but they actually refer you to the source. So as a consumer, the best way for you to get your free reports is to go straight to the source — Experian, Equifax and TransUnion.
Here are the websites and contact information for the three credit-reporting companies. Keep in mind that you can order your free annual credit report from all three companies at once by visiting AnnualCreditReport.com.
So now that you know how to request your credit report, let's talk about the information you will find inside it.
What's In Your Credit Report?
When you get your three reports from the three credit-reporting agencies listed above, the first thing you will notice is that they are all formatted differently. But while the formatting of the information may differ, the information itself will be the same across all three reports.
The information in your credit reports will likely be grouped into the following categories:
- Identifying / Personal Data - The information is this section will include your name, your social security number, and other pieces of identifying data. This information is used for identification only and does not contribute to your credit score one way or the other.
- Trade Line Info - This section will typically include any credit accounts you currently have, such as credit cards and car loans. It will also include details about each account, such as the date you opened it and your history of payments (important detail, to be covered later).
- Past Credit Inquiries - This includes the number of times somebody has requested a copy of your credit report within the last two years, such as when you buy a new car or apply for a loan of some kind.
- Collection Information - If you've had a case of overdue debt or missed payments in the past, and the case was turned over to a collection agency, that information will likely show up in this section of your credit report.
A couple of notes about the information listed above:
Payment history (mentioned within "trade line info") is arguably the most important part of your credit report, because it carries the most weight when your report is converted into a credit score. In other words, paying all your bills on time can help you maintain a good credit score.
You should also review the items listed above with an eye out for errors. For example, maybe your social security number is listed incorrectly, or maybe there's a collection notice that never really took place.
Correction Information in Your Credit Reports
So what do you do if you find a mistake in your credit report? In these cases, you should fill out a correction request at the website of the agency that produced the erroneous document. For example, if you found a mistake in the credit report from Experian, you would visit the "Disputes" section of their website to submit a correction request.
How the Reports Become Scores
Now that you have a better understanding of credit reports, let's talk about how those reports become credit scores...
Your Credit Scores
Your credit score is based on information found within your credit reports, which (as we have discussed) are maintained by the three credit-reporting agencies. Three agencies, three reports, three credit scores ... all about you!
Your history of payments on things like credit cards and car loans is a major part of your credit score, accounting for somewhere around 35% of the total number. It only makes sense why this history would be important to mortgage lenders, but it shows how you've done over the years in terms of paying back loans.
Your total amount of debt is another big component of your credit score. For example, if you have a lot of debt (perhaps more than you can afford to pay off), then your credit score will reflect this. And it won't help your cause any when applying for a mortgage loan.
Your credit score is also referred to as your FICO score, and mortgage lenders will review this score to determine your "credit worthiness" — meaning how safe or risky it would be to loan you money.
FICO is a computerized credit-scoring model named after the Fair Isaac Corporation, the company that developed it decades ago.
The big three credit-reporting bureaus — Experian, Equifax and TransUnion — use the FICO scoring model to convert your credit history into a credit score. Mortgage lenders in turn use that score to decide whether or not you qualify for a mortgage loan, and to determine what interest rate you'll pay.
Of course, there are other factors that influence these decisions, but FICO plays a leading role. In other words, your FICO score helps mortgage lenders determine your credit worthiness, how likely you are to pay off your debt, and what risk category you fall into.
The higher your FICO score the better, as evidenced by the scoring brackets below:
What is a Good Credit Score, and How Do I Get One?
When your credit score is good you will have a much easier time qualifying for a mortgage loan. But when your score is bad, the opposite is true — you will have a harder time qualifying for a loan, and you will likely pay a higher interest rate when you do get qualified.
But what is a good credit score and, more importantly, how can you achieve one?
Credit scores range from 300 to 850, and a higher score is definitely better. The higher your credit score, the easier time you will have getting qualified for a mortgage loan. You will also generally pay a lower interest rate on your mortgage when your credit score is high, and this equates to genuine (and often significant) savings over the life of your loan!
So what is a good credit score in the United States, and how can you put yourself into that range (or even higher)? Let's take a look.
A Good Credit Score by Industry Standards
Ask a dozen credit experts what makes a good credit score, and you're likely to get a dozen different responses / ranges. So for this tutorial, we have taken ten articles on this subject from ten reputable websites and averaged them out. Based on this "scientific" analysis, here's what the experts have to say on the subject of good credit scores...
- 750 or above — If your credit score falls into the range, you should consider yourself lucky (or perhaps just financially responsible). This range is considered to be an excellent score by most mortgage lenders. As a result, you will likely have a much easier time qualifying for a mortgage and getting a good interest rate on the loan.
- 700 to 750 — Credit scores within this range are somewhere between very good and excellent. With many mortgage lenders, there seems to be an "invisible line" at the 700 mark, with regard to what is considered excellent credit. So 700 and up is a great "neighborhood" to be in.
- 650 to 700 — In general, a credit score that falls within this range is considered to be good or even very good, depending on the mortgage lender.
- 600 to 650 — Now we are closing in on the most common definition of "good credit" among most mortgage lenders. A score in this range is not "very good" or "excellent," but then again it's not sub-standard or bad either. So most lenders will view a person in this range as a reasonably qualified borrower. You won't necessarily get the best rates with a score in this range, but it's still considered a good credit score so approval should be likely.
- Below 600 — If your credit score falls below the 600 range, a higher percentage of lenders will consider you to be a credit risk. You could still find a willing lender at this point, but you'll pay higher interest rates than a person with a good or excellent credit score. And this obviously translates to a larger mortgage payment each month.
What's important to note here is that people at the bottom of the scale (with scores in 400's or 500's) will have more trouble getting a mortgage loan these days than back in the 1990's. As a result of the mortgage crisis we discussed earlier, lenders have had to tighten their standards and are therefore less likely to make loans to borrowers with bad credit (subprime borrowers).
Of course, if you have a bad credit score, you shouldn't despair. There are plenty of things you can do to improve your credit, and that's exactly what we will talk about next.
Improving Your Credit Score
In a certain sense, you have direct control over your credit score. Sure, it's computer by somebody else, but it's computer based on your actions. So by taking smarter financial actions, you can in turn improve your credit score.
Here are some things you can do to achieve a better credit score:
- Pay your bills on time. This is one of the best things you can do to improve your credit, because it's given the most weight in the FICO scoring model. Paying your bills on time (credit cards, auto loans, etc.) will raise your credit score faster than any other single action. Of course, the opposite is true as well.
- Keep credit card balances low. Do your best to reduce your debt, starting with any credit cards you have. This is the second most important factor that contributes to your FICO credit score. So now you have two marching orders — pay bills on time, and pay down your debt as much as possible.
- Keep your debt-to-income ratio at 20% or lower. In other words, your overall debt should not total more than 20% of your net monthly income. If it does, focus on paying down the debt as quickly as possible.
- Limit the number of loans / lines of credit that you apply for. Applying for credit too often can send the message that you cannot properly manager your finances. Use credit and sparingly ... only when you need it.
Most of the items on this list could be summarized as being financially responsible and managing debt wisely. Put these things in practice today, and your credit score will soon reflect your efforts!
Buying a Home With Bad Credit
I'm willing to be you've heard the term "subprime mortgage" or "subprime lender" recently. This mortgage crisis of 2007 - 2008 was one of the hottest news topics of that period, and it was largely fueled by the subprime mortgage industry.
By way of definition, subprime lending is a way to grant home loans to borrowers with bad credit. A "subprime borrower" then is a person with bad credit who does not qualify for the top tier loan rates offered by the mortgage lender. In other words, a subprime borrower is a person who has had trouble paying back loans and credit lines in the past, and therefore represents a higher risk for the lender.
Here's why I'm telling you all of this:
As a result of the subprime mortgage crisis, tougher regulations have been imposed on the lending industry as a whole. This in turn means that lenders will place greater emphasis on credit scores when making loans, and also that fewer lenders will make loans to subprime borrowers. In fact, some of the largest subprime lenders of the 1990's are disappearing as I write this guide.
Here's what this means to you, as a home buyer:
Good credit has always been important when buying a home and applying for a mortgage loan. But these days it's even more important to have good credit, because the number of options for "bad credit home buying" are diminishing. That's the entire purpose of this guide, to help you understand the importance of maintaining a good credit score, and to show you ways to achieve it.
We hope you have found this guide useful, and we wish you all the best with your future home-buying experience.
In closing, we would like to offer some helpful resources with which you can continue your credit research:
- The three credit-reporting companies:
Experian.com | Equifax.com | TransUnion.com
- Where to order your credit reports:
- To learn more about your FICO / credit score:
- Consumer Federation of America:
Credit section of their website
- An FTC Consumer Alert:
Fake Credit Report Sites
- The Credit Center at Home Buying Institute:
Credit Information for Home Buyers
- Consumer Guide by the FDIC:
The New Climate for Mortgage Borrowers
Source Citation: This tutorial was originally created by the publishers of Home Buying Institute (www.HomeBuyingInstitute.com). Learn more about this subject by visiting the Credit Center section of their website.