When considering purchasing a home, our credit score follows us like a shadow. Whether this shadow is a welcome discovery like Peter Pan’s, or a little more sobering, depends on one’s credit score. However, if you’re unsure or unhappy about your credit score, don’t worry. There are easy ways to find it, improve it, and use it as a helpful tool in life’s biggest purchases.
What is a credit score?
A credit score is a numerical representation of credit history, which is a more comprehensive view of your financial background. Your credit score is a number used by lenders to determine how risky you are. A higher score means that you are less risky, meaning that the chances that you will repay lenders is higher, while a lower score indicates more risk, or a potential loss for the lender. More risk means higher interest rates to compensate for potential losses. There are many different types of credit scores, but FICO scores and VantageScores are two of the most common used by lenders (Muller). Around 90% of mortgage loan (i.e. home loan) lenders use FICO scores (Muller).
Why is credit especially important for purchasing a home? According to Investopedia, US mortgage debt reached 8.94 trillion dollars in the first quarter of 2018, making it the largest portion of US household debt. You can’t say household debt without the word house. As homes are the largest expenditure in most people’s lives, it’s not surprising that they’re associated with the highest levels of debt. Credit scores are particularly important for securing a mortgage loan with a favorable interest rate. A difference of 100 percentage points in your FICO score can mean tens of thousands of dollars of savings or payments over the lifetime of a mortgage (check out FICO’s mortgage calculator). For homebuyers, better credit means a much brighter financial future.
How are scores calculated, and what scores are lenders looking for? Below is a breakdown, courtesy of Wells Fargo, of how credit scores are calculated:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- How many types of credit in use: 10%
- Account inquiries: 10%
Essentially, history of payment or nonpayment on loans and the amounts owed to creditors versus total credit available, or your credit utilization rate, are the biggest factors in calculating a credit score. Generally, if you have a score of 600 or higher, you should be able to get a mortgage loan in the US (Muller). Experian, a consumer reporting credit company, lists a FICO score of 670 – 739 as ‘Good,’ while anything below that is considered subprime, or risky for lenders (see FICO score ranges table).
If you have bad credit, or haven’t even established credit yet, there’s no need to panic. There are strategies and counselors available to help. A good first step is to find out your credit score. Thanks to the Free Credit Reporting Act, each year you can obtain a free credit report. Equifax, Experian, and Transunion, the three major credit reporting companies, provide this service. If your score is low and if you want to buy a home soon, then it might make sense to seek out a certified credit counselor. They can help with things like debt management via credit card refinancing, budgeting, and general educational tools (Fay). If you’re looking to establish credit for the first time, a secure credit card, or one that requires a cash deposit to obtain, is a good option. This can help build your credit score with monthly payments until you’re eligible for an unsecured, or unbacked by cash, card. Some banks also offer credit cards for first time users with low spending limits. Cosigning on a loan or opening a joint credit card account with someone else (with established credit), requesting your landlord or utility company to report your payment history to credit bureaus, or joining someone else’s credit card account as an authorized user are other credit-building options (experian.com).
Credit does not have to be intimidating or daunting. It should make the home buying process easier. With the right information, assistance, and tools, credit can support our hopes to buy homes and to live without unnecessary stress.
Jordan has worked as a mortgage lender and real estate agent. He is a self-described “housing professional” with over 20 years of experience in the industry. After retiring at the early age of 50, he shifted his focus to sharing his personal wisdom with others.