There are a few things that play very important roles in the mortgage process when buying a new home. One of the most important ones? Your credit.
We are accustomed to our credit impacting things like interest rates on auto loans or approval for new credit cards. But how exactly does your credit affect the mortgage application process? And what do we mean by ‘your credit’?
Your Credit History
Your credit report is a detailed summary of your credit history, prepared by a credit bureau (there are three major bureaus in the United States: Equifax, Experian, and TransUnion). For lenders, it shows them how you have managed your past accounts and how you are currently handling debt. It also demonstrates to them whether you’ve been consistent in paying your bills and an overall picture of your financial profile.
When a potential lender pulls your credit, they will see all of your active accounts, open credit cards, any liens or judgements against you, and the number of credit inquiries you’ve had in the last two years. Your credit history will also be used to calculate your credit score; a number that plays a significant role in the mortgage loan you’re applying for.
The Mortgage Application Process
When you apply for a home loan, there are a few steps. Typically, the first step will be getting a prequalification for the mortgage.
Some mortgage lenders will offer to prequalify you for a home loan, based on what’s called a soft inquiry. This allows them to see a snapshot of your financial activity and credit score to see if you qualify for a loan (and how much they can confidently lend you). If you qualify, the lender may give you a tentative loan pre-approval offer. Soft inquiries generally have minimal impact on your overall credit score (generally a soft inquiry will take less than 5 points from your score).
However, before moving forward with the process, lenders will request a hard credit pull. This gives them access to your full credit report and history, credit scores, and more from your complete financial profile. A hard credit pull will momentarily put a ding in your credit score and lower it, but this is usually built back up over a few months of good credit behavior like paying your balance in full each month.
Lenders will use this information to determine whether you qualify for a loan and how risky you will be for them as a borrower. Lenders will also use this to calculate the interest rates you’re offered and even determine the down payment required.
If You’re Approved
Congratulations, you’re approved for a mortgage! Now, what happens to your credit once you’ve taken out a home loan?
The traditional mortgage down payment is 20 percent, but there are many more options available that require as little as 3% down.
There are some federally backed programs that don’t require any down payment, but do require good credit. Typically, if you pay a lower down payment, you’ll be required to purchase PMI (private mortgage insurance) and will pay more interest over time.
The better your credit, the better your interest rate will be. This is the case with almost every loan product, but mortgage rates weigh particularly heavily on credit scores.
The minimum credit score needed to be approved for most conventional mortgage loans is 620. However, the average credit score for all successfully completed mortgages is around 720.
If you want to pay less interest over the course of your loan, qualify for additional loan options, or opt for a lower down payment on a conventional loan, you’ll need good credit. If you have a lower credit score but qualify for a loan, you’ll most likely have a higher interest rate and higher monthly payments.
Improving Your Credit
Good credit can get you a lot of savings in the long run, so it’s worth it to take the time to work on improving your credit if you need to. With a little discipline and planning, you can quickly and consistently improve your score.
Here are a few tips for boosting your credit before buying a home:
- Be on time: When lenders review your credit report, they're very interested in how reliably you pay your bills each month. Past payment performance is usually considered a good predictor of future performance and how risky of a borrower you will be. So, avoid late payments and set up automatic payments each month so you don’t forget!
- Keep balances and overall debt low: Having balances roll over each month hurts your credit in the long run and adds to your overall debt. Credit utilization ratio is an important number in determining your credit score and is calculated by taking your overall balances and dividing it by your credit limit. You want that number low, so make sure you’re paying off your credit cards and other debts with as much as you can each month.
- Don’t open anything new or close old accounts: This may seem counterintuitive, but you don’t want to close any old accounts. This actually reduces your credit score and every time you open a new credit account, you also get a credit reduction from credit inquiries. Open new accounts if needed, but try and keep it to a minimum (and spread out - don’t open new accounts all at once).
- Create a healthy mix of debt: You want to show lenders that you have a diverse financial portfolio. If your credit report is sparse or only has credit cards, you need to work at improving your credit mix. This might mean adding an installment loan or giving your history more time to build.
Aside from knowing what you can actually afford, your credit is one of the most important parts of the mortgage application process. Start working on your credit report long before you’re ready to buy - this could save you stress, and thousands of dollars, through the homebuying process!