I have been teaching The Village’s Homebuyer Education class for over 4 years now. As part the class, I teach prospective homebuyers about credit scores. We talk about what makes up a credit score, what information can be found in the credit report, and how the credit score can impact families that are in pursuit of the American Dream of homeownership.
This is often a favorite part of the course for participants because credit scores can be rather mystifying. So many different factors come in to play with the scores. And what’s more, the credit scoring rules can, at times, seem to defy common sense.
Credit scores are a major factor in a home purchase. Because of this, it is important to understand some of the credit scoring mistakes and myths that you may be unaware of. A few of the following are even factors and rules that, if ignored, could take someone from being qualified for a mortgage loan to having to wait 1-2 years before being able to qualify again.
• Paying off older small collection accounts before getting a loan: If someone has a number of small collection accounts, common sense would tell you to pay them off before going to apply for a loan. While it’s true that in most circumstances, you will need to take care of these items, you will want to be cautious when doing so. If you wish to purchase a home in the immediate future, you will want to consult with a mortgage lender before paying these older collection items off. It is not uncommon to see a credit score drop substantially from paying off older collection items. This happens as a result of having the older collection items refreshed with a current date.
• Closing open credit card accounts that have not been used for a while: A major factor in credit scoring is the ratio of credit in use compared to available credit. When you close open credit card accounts you eliminate the available credit and thereby affect this ratio. If you were to close a number of open accounts that have no balance, you could negatively impact your score. If want to buy a home in the near future, it would be best to wait until after you have completed your home purchase before closing these accounts.
• Making a large purchase before closing on a home loan: If you have been pre-approved for a home loan and are making an offer on a house DO NOT go out and make a large purchase. Don’t buy a new car or purchase furniture for the house you are buying. Don’t make any large credit moves until you have completed your home purchase. New credit debt could potentially disqualify you for the home loan. Most lenders I have worked with have heart-wrenching stories about buyers making purchases that caused the home loan to fall through at the last minute.
• I have no credit score so I can’t get a home loan: While it’s true that having no credit score at all does make things a bit more difficult, it does not automatically disqualify your for a home loan. Some lenders have the ability to use what called non-traditional credit. They can essentially create a credit report and score for someone by collecting payment history on a number of items that don’t typically report on a standard credit report. They can collect payment history for your rent, utilities, phone, etc. to create this non-traditional credit.
• My bad credit will be offset by my co-signers good credit: When a lender pulls the credit of a 2 people that are going to purchase a home together, they aren’t going to average your combined scores. Lenders don’t overlook your bad credit because your co-signer’s pristine credit. Everyone has 3 credit scores, one from each of the 3 major credit bureaus (Equifax, Trans Union and Experian). To qualify for a home loan, standard guidelines require lenders to use the middle score of the borrower with the lower scores. So, while a co-signer can help qualify you for a loan by factoring in their additional income, you still need to have an acceptable credit score to qualify.
• Shopping around for home loans will hurt my credit score: When lenders pull your credit it is called an inquiry on the credit report. Inquiries do have an effect on the score and multiple inquiries for credit cards in a short period of time can negatively impact your score. However, in order to be a savvy consumer, it is important to compares rates and fees with different lending institutions. The credit score takes this in to account and does not punish you for being a smart about getting a home loan. As long as you are comparing loans within a 30 day period, the credit scoring model only counts these multiple credit pulls as 1 inquiry. But, be warned, this is only the case for installment loans like a car or home loan. If you apply for 5 credit cards in 1 week, it is going to count as 5 and will probably drop your credit score.
When it comes to credit, it pays to be smart. And if you want to own a home someday, it has pretty much become a necessity. Review your credit report often and when in doubt, ask an expert. Meet with a trusted lender or talk to a consumer credit counselor like me. Whatever it takes, educate yourself on how credit reports work.
For more info about money management, visit The Village Financial Resource Center blog.