When you get ready to buy your first home, or to buy another after a long period, there are some things you’ll need to know about credit—and some things you may even learn about yours that you never knew. Credit, of course, determines whether you can secure a mortgage to buy your dream home, so getting into the nitty gritty is a good first step.
You need to update yourself on your credit situation and get your details cleaned up, to help improve your rating and secure the lowest possible interest rate (and save on both your monthly payments, and the long term cost of your investment).
One of the largest factors a lender considers before lending you money is your debt-to-income (DTI) ratio. Essentially, it is the percentage of your income that you pay each month to your debt. It’s an easy formula: your monthly gross income divided by the amount you pay in debt. The debt included in this formula is:
- Credit cards
- Car loans
- Student loans
- Personal loans
- Open credit lines
- Medical bills
For example, say you make $3,000 a month in gross income. You pay $300 on a car loan, $500 on your student loans, and $200 in credit card bills. $3,000 / $1,000 = 33%. Your DTI is 33%.
Your goal should be for your DTI to be less than 45%. By paying down debt or finding new sources of income, you can positively help your DTI.
Avoid Large Purchases on Credit
Before applying for a mortgage and closing on your home, you don’t want to make any large purchases on credit. You might think that, after you get approval for your mortgage, it’s okay to buy some new furniture or appliances on credit.
It isn’t! Before the closing, the lender runs one more credit check to make sure nothing has popped on your report. Wait until after closing on your home to make any new purchases.
Hard Inquiries Vs. Soft Inquiries
You may have heard that applying for a loan can ding your credit score; but you’ve also seen ads where it says applying won’t affect your rating. There are actually TWO types of credit inquiries, hard and soft.
- A soft inquiry is one that doesn’t involve an application for credit of any kind (e.g., an employer checking your credit history, or you reviewing your report). These don’t affect your credit.
- A hard inquiry is a credit application—and applying for a mortgage is a hard inquiry.
It’s still a good idea to compare rates with several lenders before choosing a mortgage product—just apply at roughly the same time, within a few days of each other, because then the events get treated like a single inquiry.
Closing Credit Accounts
You might be tempted to pay off and close your credit accounts, but doing so might actually hurt your credit limit because it lowers the amount of credit you have available while raising the percentage of available credit that you’re using.
For example, you have three credit card accounts with a limit of $1,000 each. You owe $500 on two of your three credit cards. At the moment, you’re using 33% of your available credit. If you close the credit card account without a balance, the percentage of credit used jumps to 50%.
This is why many advisors suggest you DO pay off your credit cards, but DON’T close the accounts. (Note: if you have an installment loan, paying it off won’t necessarily increase your credit rating—but it will lower your DTI ratio.)
One more thing to know about credit before buying: Remove Collection Accounts
Maybe it’s a forgotten medical bill or an old utility statement, but collection accounts can put a dent in your credit score. In most cases, if you’re willing to pay the bill in full or negotiate a lower settlement amount, you can call the collection and arrange to have the account removed from your credit report.
So, in the months before you start house hunting, it’s a good idea to get your credit in order to get the lowest possible interest rate. You might want to take a look at this other recent article for more steps that can help you get ready to apply for a mortgage, too.