Almost anyone who wants to buy a home knows that their credit plays an important part. They may not know precisely how. This guide walks buyers through the essentials of credit scores, and how they affect the lending and home buying processes.
Credit Score Basics
When people first start thinking about applying for a mortgage, they might wonder about their credit scores. The common understanding about credit scores has changed over the years, so buyers should invest some time into learning what is currently true. This will help to avoid confusion or mistakes in the process. At the most basic level, credit scores range from 300-850. There are three different credit reporting agencies: TransUnion, Experian, and Equifax. For the past several years, these agencies have created their own scoring algorithm, called VantageScore.
An independent organization, Fair Isaac Corporation (FICO), makes the credit scoring model that most lenders use. With three agencies reporting credit history and generating their own scores, people commonly assume that everyone only has three credit scores. In fact, there are different versions of the FICO scoring model to determine an applicant's score. When a home buyer requests a copy of their credit report and credit scores, they usually get the most recent versions of the score. They may have to order a different product to get older versions.
How Credit Scores Change
A person's credit score goes up and down from month to month. This might relate to:
- credit utilization
- opening or closing credit accounts
- debt payoff
- late payments or charge-offs
- old reports falling off the record
As a general rule, any event that could negatively affect a person's credit will stay on the report for at least two years. A foreclosure or bankruptcy could stay on the report longer. Credit scores are broken up into certain components, like timely payment, total debt, types of accounts, new accounts, and the length of the credit record. A person's payment history and the money they owe make up the biggest portion of the credit score.
Why Mortgage Lenders Check Credit
Since credit is built over a lifetime, it tends to paint a fairly accurate picture of an applicant's ability to handle debt. A mortgage is typically the largest debt on someone's credit report, and most people spend decades to pay it off. As such, the lender wants to be sure that a borrower is prepared to handle the responsibility. The credit score becomes a quick reference for the lender, to help them understand what kind of applicant they will be dealing with during the home buying process. This is why many lenders will perform a quick credit score check at first, and then pursue the details of the credit report in depth if they think the applicant will qualify.
Credit Scores and Loan Approval
A person's credit score does not tell a lender everything about the person's use of credit, but it is still important for the mortgage process. For example, someone with a more limited credit history due to their age might have a lower score, despite a perfect payment record. An applicant who went through a foreclosure several years ago, but who has paid everything on time since then, may also have a lower score. The reason that people in these situations do not score as high is all about risk. The lower the score, the higher the risk.
In the interest of efficiency, many loan programs call for a minimum credit score in order to qualify. For conventional loans, lenders can offer a mortgage to people with a score as low as 620. FHA loans start at 500 for a credit score. People who get in with scores like these are usually required to provide extra support to balance out the risk, like a larger down payment or greater assets in reserve.
Improving a Credit Score
Since the actual credit check is such a simple part of the application, buyers should be prepared with their best credit before they start shopping around for mortgages. Lenders expect scores to fluctuate slightly during the process, but a large change could signify a problem. Interested buyers can start a few months in advance by getting a copy of their credit reports and looking for inaccuracies. Mistakes in the report could affect the credit score. Otherwise, the best things buyers can do to get their scores up is to pay off debt (especially revolving debt), avoid opening new accounts, and keep all debts current.
Buying a home takes time, money, and a specific credit score. By using this information, Meadowwood home buyers can get ready to apply for a mortgage.