You're likely aware that your credit standing plays an important role in a lender's decision to approve you for a home loan.
In some cases, this can be the factor that separates the homeowners from the renters, so it's important to understand your own credit and what you can do to improve it before applying for a mortgage. Not only is good credit a mitigating factor for whether you're even approved, it is also the key to getting more favorable loan terms, such as a lower interest rate.
Why credit matters
Unlike money you borrow from a friend or family member, mortgage providers need more than a borrower's word and good faith before they offer real estate loans. Your credit history, savings and FICO score tell lenders whether you're prepared for such a large financial undertaking and, if you are ready, the likelihood that you'll be able to make regular, on-time payments. Considering the size of home loans and the number of borrowers lenders speak with, it's no surprise that they have a strict process for deciding who can receive a loan.
What lenders like to see
Although each mortgage provider has its own parameters for whether to approve you for a home loan, there are a few factors that are consistent:
- Credit history: Your credit history is a report of all your credit accounts. It includes all the credit cards, student loans and auto loans that you've opened in the past. Additionally, it tells lenders whether you've defaulted on any previous loans and whether accounts were closed. This information can be ordered for free, but only once a year from each of the three major credit reporting agencies: Experian, Equifax and TransUnion.
- Credit score: This is not the same as your credit history and is typically not included on those reports. Your FICO score is a three-digit number that ranks your creditworthiness. A score of 720 or higher is typically regarded as excellent. The parameters for mortgage approvals vary by lender, but scores as low as 620 can be eligible for special loans, such as those offered by the U.S. Federal Housing Administration. The average low- and high-end scores for approved borrowers fluctuate with the housing market and lending standards.
- Debt-to-income ratio: This percentage tells lenders how much of your gross monthly household income is devoted to paying debts. If your DTI ratio is too high, you may not be ready to take on another debt as sizeable as a mortgage. As a result of the Qualified Mortgage rule of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, lenders who offer a QM are required to impose a strict DTI cutoff of 43 percent.
How to improve your credit
If you're afraid that your current credit standing could make you ineligible, you're not alone. Many potential borrowers feel the same way, and the good news is that there are ways to have more favorable credit before you apply for a home loan.
If you have a large amount of outstanding debt, the first step is to pay off as many of those accounts as possible. It's typically easier to start with credit cards. However, avoid closing credit cards and other accounts in the months before you apply for a mortgage, as this is a bad sign to lenders. The same goes for opening new accounts. Each time you apply for or open a new line of credit, your credit report will note a new inquiry, which affects your FICO score.
Always keep in mind, however, that lenders look at many factors when approving borrowers for loans.
For more information about mortgages and credit approvals, visit LandmarkBank.com.
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