If you’ve been saving for years in the hopes of buying a home, you’re probably also keeping close tabs on your credit score since it’s a key factor of the home purchase, impacting how large of a loan you can take out and what your monthly payments will look like.
But what happens to your credit once you’ve taken out the loan? Here’s all the information you need to understand your FICO score, make sure it’s as high as it can be before you apply for a mortgage, and keep it there after your home loan goes through.
What’s behind a credit score?
Your FICO credit score is calculated using a variety of factors. Here’s a definition of each of them, how much they impact your final score, and how you can improve your number in each category.
Payment history (35% of your score)
This assesses your past and current accounts to see if you’ve made your payments on time. Because it is worth over one-third of your credit score, it is very important that you always make payments on time. Set up autopay with your credit cards so you’re never late on a payment!
Amounts owed (30% of your score)
It’s ok to have debt, but if you are carrying large balances — maxing out credit cards, for instance — and the percentage of debt is over 30% of your available credit, your score could be negatively impacted. For instance, if you have $10,000 of available credit, you’ll want to keep your debt below $3,000.
Length of credit history (15% of your score)
Generally speaking, the longer you’ve had available credit, the better this portion of your credit score will be. It might be a good idea to keep some older accounts open, even after you’ve paid off the debt, because they’ll show you have a long credit and payment history.
Credit mix (10% of your score)
This measures the type of debt you’re carrying — credit cards vs. student loans vs. mortgages. It’s not important to have all of these; the credit mix represents a very small portion of your credit score. However, this could be more important if there’s not a lot of other information on your report to score.
New credit (10% of your score)
This score considers the amount of new accounts you’ve opened in the last year; if you’ve opened several new accounts in a relatively short amount of time, you could be seen as a risky borrower.
Is my credit good enough for a loan?
Lenders generally look for a credit score over 620 for a conforming loan, but a score of 700 or above will help you get the best rates out there.
If your score isn’t quite there yet, consider taking these steps to improve it:
- Review your credit report regularly (get one from each of the three biggest reporting companies: Experian, Equifax, and TransUnion) — does everything look accurate?
- Report any errors you find on your report to the credit bureau that made the error.
- Pay any outstanding collections.
- Pay off some credit card balances. As we noted earlier, credit utilization is 30% of your score.
- Don’t take on any new debt.
Camilo Maldonado, creator of The Finance Twins and featured contributor to Forbes, stresses the importance of raising your credit score, even by a few points: “Working to improve your credit over time can pay big dividends in the form of a lower interest rate. The average mortgage is several hundred thousand dollars, which means a slight improvement in interest rates can make a large difference in the amount of money you’ll pay for your home.”
But don’t fret if your FICO score is still below 700; it’s only one of several elements affecting your home loan options. Generally speaking, lenders will look at “The Five Cs”: character, capacity, capital, collateral, and conditions. Here’s a brief overview of those:
- Character — your credit history.
- Capacity — your debt-to-income ratio.
- Capital — the amount of money you have on hand.
- Collateral — an asset that can serve as a security against the loan.
- Conditions — the reasoning for the loan, the amount of the loan, and relevant interest rates.
Camilo also notes that if you have less-than-stellar credit but want to buy a home now, you can always work to improve your credit after you buy and then refinance your loan down the road, hopefully qualifying for a much better interest rate.
How your mortgage loan affects your credit
Spoiler alert: expect that FICO score to drop. This is totally normal, though, because you’re taking on a huge line of debt, presumably much larger than any other credit line you have opened in the past — most home loans will be at least six figures.
Also, before you even take out the loan, you’ll be running hard pulls on your credit to get your preapproval lending letters in order. Preapproval is an important step in the buying process; according to top agent Matt Healey (of the successful Josh Pomerleau team — he’s helped close more than 1,300 transactions!),
“In a competitive market, agents recommend that folks get approved with two or three lenders depending on how their credit score is and what their overall financial picture looks like. Some sellers might have a positive or negative connotation towards a specific bank, so with multiple preapprovals, the seller can see options, and see that the financial strength of the client is pretty high.”
If your credit is in good shape, don’t worry too much about these inquiries. As long as they are happening within a short timeframe, they’ll only show up as one credit inquiry and have minimal impact on your credit score.
The average drop in credit score is 15 points, though some borrowers could see it drop as much as 40 points, if they already have a lot of debt. Since you’ll be taking on a huge new loan, you’ll want to hit the pause button on opening any other lines of credit until your score bounces back.
Ways to boost your credit score back to where it was
That initial ding on your credit score might sting a bit, but it’ll likely be temporary: according to Maldonado, “the most important thing you can do to improve your credit is to make all of your credit payments on time, every time. If you want to quickly improve your score, you can lower your credit utilization by paying down any credit cards or loans you have outstanding.”
if you keep your new accounts to a minimum (don’t rush out and charge a bunch of new furniture on your credit cards!) and pay your bills on time, your score will jump right back up to where it was, usually in about a year (sometimes faster, around five or six months). If this is your first home loan, your credit score might even end up a bit higher than where you started out, thanks to the fact that you’ve diversified the type of credit open in your name.
We recommend signing up for auto-pay, so you don’t even have to think about which bill is due when — and your payment history score will gradually improve.
There’s no way to avoid a small dip in your credit when you take out a home loan — remember that these loans are huge (probably one of the most — if not the most — enormous loans you’ll ever sign your name to), and it’s perfectly normal for your credit to take a hit.
The key is to do what you can to help your score bounce back — paying all those bills on time and reducing the amount of new credit. It’s also wise to talk to a seasoned real estate agent; they’ve dealt with a variety of financial situations, and will be able to help guide you to make the right choices given your particular scenario.
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