Financial blogger Ash Cash shares insights on how to give your home-buying plans a (credit) gut check.
Potential first-time homeowners are often anxious about how their credit impacts their ability to qualify for a mortgage loan. The qualification process can be daunting when you're unsure about your credit profile, and credit is just one of important areas of concern for first-time home buyers. It's always a good thing to test your credit knowledge, which you can do by answering the questions below. If you know the answers to them all, you should feel good about your understanding of your creditworthiness as you prepare to kick off your home search.
1. Am I current on all of my credit obligations?
Lenders want to be confident you'll make your mortgage payments on time and in full each month. Since they can't predict the future, they look first to your payment history to see how you've handled your debts in the past A good payment history may indicate that you are a low credit risk. Your payment history is usually one of the major components of your credit scores, so late or missed payments, accounts in collections, foreclosures and/or bankruptcies can negatively affect your creditworthiness quite a bit. Because of this, it's important to keep current with all of your credit obligations.
2. What is my credit utilization ratio?
Your credit utilization ratio (the total outstanding balance on all of your credit cards and revolving lines of credit combined, divided by the total amount of credit available to you) is also a major component of many credit scores. Using up all of your credit — or getting close to it — can signify to lenders that you have a high dependency on credit, which can negatively impact your credit scores. To follow a good rule of thumb, keep your credit utilization below 30 percent of your available credit limit.
3. How established is my credit history?
The length of your credit history is another factor lenders may consider when determining your creditworthiness. The longer your credit history is, the more it shows that you've been responsible with credit for years, or even decades. Potential lenders like to see that you have balanced your credit obligations successfully over a long period of time before classifying you as a good investment. The rationale is that a person with little or no credit history is a lesser-known entity who could be substantially more of a risk with credit. One thing to consider if your credit is already established: aged accounts with a long and positive credit history can be beneficial to your credit scores for this exact reason. Carefully evaluate the potential impact that closing those accounts may have on your scores before losing the value of their established records.
4. How diverse are the types of credit that I'm using?
A good credit mix — such as one with credit cards, student loans, an auto loan, etc. — shows that you can manage the variety of obligations that come with using different types of credit. As you become a more established credit user, you'll have the opportunity to use credit in different ways. Some credit scoring models consider this in their calculations, though it may not be a major component, as there are hundreds of credit scoring models that are all calculated differently.
5. Do I have too many new accounts?
New credit, or your credit mix, may not be a major component of your credit scores, but it can play a role in the overall picture. Lots of new credit card accounts — or lots of inquiries generated by multiple applications for credit cards or other loan types — may portray you as a riskier investment to a lender. A few inquiries when shopping for financing for a new automobile, however, will likely not be harmful. Similarly, checking your own credit counts as a soft inquiry and will never impact your credit scores.
Soft inquiries on your credit report are only visible to you, except: (1) insurance companies may be able to see other insurance company inquiries; and (2) inquiries by debt settlement companies you have authorized to access your report may be shared with your current creditors. These inquiries have no effect on your credit score as they are never considered as a factor in credit scoring models. Soft inquiries are not disputable but are available for reference.
6. Do I have an acceptable debt-to-income ratio?
Your debt-to-income (DTI) ratio doesn't speak to your creditworthiness per se as other elements do, but having a high DTI can affect your chances of getting a mortgage loan. "Your debt-to-income ratio," Experian notes, "is the total of all your monthly debts, including installment loans, divided by your total monthly income." Because your income is not part of your credit report, lenders will ask you about your income separately on your credit application. They will also most likely ask that you provide proof. Your DTI is important because it gives lenders a sense of how much additional new debt you can handle. While the acceptable DTI ratio varies by lender, it is a good idea to meet with a loan officer at your financial institution prior to seeking financing for a home to determine how much of a monthly payment you can afford.
So, how'd you do? If you were able to answer each of the questions above, you're well on your way to understanding how your credit stacks up and what it can mean for your home search process. It's never to late to set out in search of the right place; once you find it, approval for a mortgage loan might be within your grasp.
Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Experian