Understanding how credit scores and reports work in a mortgage transaction helps you save money with any type of loan. Having good credit score on your report helps you to be eligible to get a lower interest rate. It also assists in reducing the amount of mortgage insurance (if applicable) you pay on a conventional loan. I’m here to help you understand what you can do for your credit to get a lower interest rate and ultimately a lower payment for your mortgage. Let’s break down some key points about credit that I wish I had understood at a younger age. This article will help those seeking to purchase or refinance a home, and those who plan on getting any loan in the future. So yeah, this article should be helpful to pretty much anyone that’s seeking a loan now or in the future.
Use Credit Responsibly
I first want to emphasize at the beginning of this article a concept that I was taught about credit. My goal as a Mortgage Specialist is to always help others the best I can. I do not want them in a financial position they cannot afford. This advice is probably not a sales pitch a loan officer usually makes (HAHA!), but here it goes. This concept has given me peace of mind as I have applied it and I know it will give you peace of mind too.
There are very few things in life that we should use credit for. A mortgage, a car, and an education are items that make most financial sense when seeking a loan. In most cases, people do not have enough money to buy any of these outright. A mortgage, a car, or an education may be needed and, in some cases, even an investment. Do all that you can do to avoid unnecessary debt. If you HAVE to put it on a credit card, you do not have money to buy it. Apply that concept and you will sleep better.
Credit is not something that should be taken lightly. I recommend to anyone responsible, 18 and older, to seek a credit card if they don’t have one. Be responsible with it. Let it work for you and not against you. Do not treat credit like it’s money that you have, because it is NOT money that you have. It’s money that you will need to pay back. The debt will haunt you and make you lose sleep if you cannot afford it.
Credit can be your friend or your enemy. It all depends on what you do with it. Try your hardest to pay your credit card off every month and do not spend money that you don’t have. Credit can be a slippery slope if you start to use it when you can’t afford to. Bad credit and debt can ruin you financially for years. Now, let’s get into some credit basics.
Credit Basics
Establishing good credit at a young age will help you to get loans and save you money. This includes student loans, auto loans, and the big one: Mortgage/Home Loan. Credit needs to be taken seriously and with maturity. If you are not responsible with money or credit, you may just dig yourself in a hole that will take years to recover from. Take credit seriously and understand how it can impact your life. Here are some basics of how credit works.
There are three main credit bureaus. A credit bureau is a company that reports certain debts, public records, and other personal data on your personal credit report. In order to take out most loans, a satisfactory credit report or score is required. In some cases, no credit means no loan. The three main credit bureaus are Experian, Transunion, and Equifax. Each bureau uses a different algorithm to report a “credit score”. Credit scores range from 300-850.
300 is an ugly score. So ugly in fact, that you can tie a steak around that credit score and the dog still won’t play with it. 850 is a perfect score. An 850 just might be too good to be true. I have pulled over a thousand credit reports and have never seen a 300 or an 850 credit score. I have found all types of scores in between and they are often different for the same person with each bureau. The good news is that the basic principles of the algorithms for each bureau are similar.
If you have limited credit accounts with low balances and you pay your bills on time each month, your score is likely to be good (700+). If you missed a payment in the past or have high balances, your scores will likely be okay (620-700). If you don’t make payments or are constantly late on payments, your scores will be ugly (less than 620). These are my general classification of the type of scores and there are several factors that increase or decrease your actual scores.
Credit Tradelines
An account that reports on your credit is called a tradeline. Each tradeline on your credit report will reflect the creditor, an account number, what type of an account it is (mortgage, installment, revolving), any late payments associated with the account (30, 60, 90+ day lates), the credit limit, the balance at the time of the creditors last reporting cycle, and the minimum payment amount.
The creditor is the company who extended the credit to the consumer. An account number is the number associated with each individual account. A mortgage is a loan on a home. The mortgage can be an installment or a revolving account like a Home Equity Line of Credit (HELOC). An installment loan is associated with auto loans, student loans, or personal loans. Installment loans are issued with a specific loan amount upfront and are paid down each month until the balance is zero.
A revolving account is most commonly associated with credit cards. There is a max credit limit and the consumer can use as much money as the credit limit allows. The consumer may pay the minimum payment or the entire balance. This causes the balance to fluctuate up or down and is considered to revolve.
A late payment will reflect on a credit report after the payment is 30 days late and a record will be kept for how many late payments there have been on each tradeline. The balance reflected on a credit report is not always the exact balance on the tradeline. Creditors report to the bureaus on a monthly basis and can take 30 to 45 days to report any changes on the account to the credit bureaus. A loan specialist may be able to expedite the correction, depending on the circumstances, if this is an issue.
The minimum payment that reflects on the credit report may vary with revolving accounts, but is fixed on installment loans. The minimum payment amounts are used in calculating debt-to-income (DTI) ratios for a home loan when required by the specific type of loan. Credit reports will also report when the account was opened and the date of last action was taken. This records how long an account was open and how active the account is.
The Good
Most credit cards offer some type of rewards program. Some are better than others. When you use your credit card and pay it off each month, you will typically not be charged interest. Interest starts accruing on the credit account when you carry a balance. You will get the rewards (if available) on most cards either way. This can lead to you saving up rewards to get something nice, or perhaps even a flight to another country. This is done just because you used your credit card to make purchases. Sounds pretty good right?
Well let’s take this a step further. You’re being responsible with the credit you have and it is showing on your credit report. You decide it’s time to get a loan. The loan officer pulls your credit and you have a good score. You are likely to be rewarded with a better rate or terms compared to someone who did not stay on top of their credit. The process should be smoother too. That’s extra time and money in your pocket!
The Bad
Credit cards accrue interest when you carry a balance. Interest rates on credit cards are usually high, which means you will be losing money. You need to pay attention when your bill is due. If you miss your payment deadline you may be subject to more fees and possibly a late payment reported on your credit report. Late payments can have a huge negative impact on your credit score.
Some people end up filing bankruptcy because their credit has become so bad and they owe so much money to their creditors. I know sometimes life happens and life can be rough. Just be as proactive as possible when using credit. I think you get the point. Try your hardest to use credit responsibly.
Credit Tips
Here are a few tips to help you establish a good credit score.
- Have a good credit history. Having no credit accounts will not help. You need a credit account and you need to use it wisely. The longer you have an active account in good standing, the better.
- Your balance of your credit card (revolving credit) should always be below 20% of the credit limit. Never let is exceed 20% if possible. Once you get into the area of 30%, your credit scores may take a hit. If they are maxed out, it’s going to hurt.
- Use your credit card. If you do not use it, there will not be activity showing on your credit report. You want to show that you are responsible with credit. By using it and then paying it off each month, it will help your credit score and show any lender that you are responsible with credit.
- Pay attention to when your bill is due. You need to pay your bills on time. Any late payments will negatively affect your credit score.
The best way to start having credit reported is to find a place that offers a credit card with a small limit. Be excited about it. Use it wisely and increase the limit as you learn to use it. It’s a great step toward getting a good interest rate on your next home loan. Perhaps it will even be your first step to getting a home loan. If it is, I congratulate you!
Conclusion
Good credit is necessary to have access to the best interest rate available. It will take planning and discipline to get your credit established and on a good track. When credit is used responsibly, it will likely save you time and money when you get your next loan. Pay your bills on time, keep your credit balances low, and maintain at least one tradeline of credit.