5 steps to a mortgage-worthy credit profile
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You’ve been diligently pinching pennies to save for a down payment and after countless hours of drooling over online “For Sale” listings, you’ve decided it’s time to make your dream of owning a home a reality.
But is your credit mortgage-worthy?
|HOW TO PREPARE YOUR CREDIT TO QUALIFY FOR A MORTGAGE|
To find out, you’ll first need to meet with a loan officer to see how much of a mortgage you qualify for and at what interest rate.
After sitting down and going over your finances with the loan officer, though, you may discover that instead of penny-pinching and dreaming, you should have been working on building up a more positive credit rating. The lender may say you need to improve your credit before you can qualify for a mortgage. Now what?
The majority of homebuyers – 88 percent, according to the National Association of Realtors’ 2017 Profile of Home Buyers and Sellers – finance their purchases, so unless you have tons of cash lying around, prepare to have your finances examined under a microscope.
Here are five steps to get your credit and finances in tiptop shape:
1. Check your credit reports.
The ultimate goal when securing a mortgage is to get the lowest interest rate on your loan. To get the best interest rate, your credit has to be as clean as possible.
Pull copies of your credit report by visiting annualcreditreport.com, where you are entitled to a free copy once a year from each of three credit bureaus – Experian, Equifax and TransUnion.
The information listed on your credit reports shows lenders how long you’ve been managing credit, how much debt you have and how diligent you have been about making payments.
That data feeds into a mathematical formula, which calculates your credit score. The most common credit scoring formula, FICO, ranges from a low of 300 to a high of 850. Anything over 740 is considered excellent.
To see where you stand, check your credit score. Check your bank or credit card issuer’s website as an increasing number of banks and credit cards offer free credit scores.
For example, Discover offers a free FICO score to all consumers, regardless of whether they are Discover cardholders. CreditCards.com also offers a free VantageScore (which has the same scoring range as FICO's) and a free TransUnion credit report.
When poring over your credit reports, look for even the smallest errors, which aren’t uncommon, said Bill Cosgrove, CEO of Union Home Mortgage Corp.
“Sometimes family names can be very similar, even if it just comes down to a junior or senior title, and that has to be checked for accuracy,” he said. With similar names or Social Security numbers, you may find someone else’s accounts inaccurately mixed in with yours.
“Other times, consumers will have a collection on their credit report that has been there for years, and they are not aware of it and that will need to be cleaned up,” Cosgrove said. According to a Federal Trade Commission study, about 1 in 5 Americans can find an error in one of their reports, and about 1 in 20 has an error serious enough to result in a higher interest rate.
If you find errors, gather documents supporting the correct information, draft a dispute letter and mail the paperwork (return receipt requested) to one of the credit bureaus (which is required to notify the other two). Also, contact the creditors reporting the erroneous information and alert them to your findings. The credit bureau has 30 days to respond to your dispute.
While it may take some time to get the errors resolved, it will be easier to deal with them now rather than when you’re ready to start looking for a home but can’t get a lender to draft a preapproval letter because your credit is less than stellar.
2. Cease major credit-related activities.
The closer you get to submitting an application for a home loan, the fewer big purchases, credit additions and life changes you should be making.
“Limit the amount of inquiries or applying for new credit when you know a mortgage application is in your future,” said Katie Bossler, personal finance counselor for GreenPath Financial Wellness. “You want to stop all that activity. It’s a smaller factor, but it does help determine your credit score. As a rule of thumb, don’t apply for anything you don’t need.”
It’s in your best interest to keep your credit profile strong and quiet when you begin the homebuying process.
“Do not increase your debt at all, don’t decrease your savings, don’t do anything big financially,” said Mike Sullivan, a consultant in personal finance in Phoenix. “Don’t change your employment. Although lenders typically hate to cancel applications, they will if they believe there is a new lending risk.”
3. Reduce what you owe.
Before you take on a mortgage, stop carrying a balance on your credit cards, charge only small amounts and pay early.
“When you apply for a mortgage, they are going to check your debt-to-income ratio, meaning they are going to check how much you make compared to how much debt you owe,” Sullivan said.
While income doesn’t factor into your credit score, it will be taken into consideration by a mortgage lender.
“Banks are typically comfortable lending out 28 percent of your gross monthly income to mortgage payments,” Bossler said.
However, only you can determine the monthly payments you can afford to add to your existing budget, so don’t automatically agree to take whatever size loan a bank offers you. The lender isn’t familiar with your spending habits and other living expenses.
In some instances, your debt-to-income ratio may limit the types of mortgages you may qualify for.
For example, according to the Consumer Financial Protection Bureau, if your debt-to-income ratio is more than 43 percent without a mortgage, you may not be eligible for a qualified home loan.
Qualified mortgages typically cap fees, exclude harmful loan practices, such as loan terms longer than 30 years, and limit how much of your income can go toward your debt, the CFPB says.
Overall, to get the best terms and protections, don’t apply for a mortgage until you’ve reduced your debt-to-income ratio as much as possible.
4. Give yourself time to improve credit weaknesses.
Dedicate some time to make your credit and overall financial health as strong as it can be.
“Evaluate where the areas of opportunity are,” Bossler said. “For example, if bills have been late in the past or if there is something late now, figure out how to bring past due things current and keep them current. Having that pattern of paying bills on time is key.”
Repairing past credit mistakes takes time, and you may have to adjust your prospective timeline for buying a home accordingly. For example, if you have a poor payment history, it might take anywhere from six to 12 months to improve your credit sufficiently.
In addition to addressing issues that directly affect your credit score, tidy up all the other areas of your financial life.
“The next thing is you have got to make sure your income tax is paid and you have no IRS liens,” Cosgrove said. “The same goes for back alimony or child support.
“And, a lot of times, when it comes to divorces and separations, lenders will need to see the separation decree. Sometimes that affects the lending process if you don’t have all the right paperwork.”
These are just some of the issues that can bog down – or stop – the mortgage application process.
5. Start saving and revise your spending budget.
Taking on a mortgage is more than just establishing a credit profile that lenders find acceptable. Owning a home comes with more financial responsibilities, so get used to living on a stricter budget.
“You don’t want to finally get into a home and then really struggle financially,” Bossler said. “There are a lot of financial situations that come into play in the mortgage process that don’t normally come into play in other aspects of your financial life.”
Start the financial adjustment process by revisiting your monthly spending budget well before taking on a mortgage and the affiliated expenses of homeownership.
“When you are going to apply for a mortgage, a lot of time you are going into it blind and you really need to try and get set up on a budget before getting started,” said Jack Wilson, homeownership department manager for Alliance Credit Counseling.
The down payment and closing costs are two obvious expenses for which prospective homebuyers should start saving.
However, while 61 percent of homebuyers use savings as a down payment for a home, 35 percent use money received from the sale of a previous home, according to a 2017 report from the National Association of Realtors. However, 13 percent of all surveyed homebuyers said saving for the down payment of a house was the hardest part of the homebuying process.
“American consumers are not patient people and like immediate gratification,” Sullivan said. “It’s an alarming statistic in one way because that means people don’t save and aren’t going to be prepared for those other costs. If you don’t have a savings habit when you buy a house, you will have difficulties.”
The size of a down payment required for your desired mortgage may vary, but most conventional lenders will require 20 percent down. If you are looking at buying a $200,000 home with 20 percent down, that means you’ll have to save $40,000 in addition to closing costs, which are typically 2-5 percent of your total loan.
If you don’t have such a down payment ready, you may be able to get away with paying 10 percent or less, but it will cost you. Putting at least 20 percent down on your home loan demonstrates you are a less risky lender, could lower your interest rates and also eliminates your need to pay private mortgage insurance to your lender each month.
The more you can pay upfront, the more you’ll save in the long run.
The home itself is not the entire expense. You’ll also have to make room in your budget for things such as home repairs, renovations and furnishings.
“Very few people will actually budget for window coverings, landscaping, those kinds of things,” Sullivan said. “You can only put sheets up for so long.”
If you’re moving up from an apartment, expect bigger utility and insurance bills, too. The more you can save and anticipate changes now, the less likely you’ll be to accumulate more credit card debt later.
“Everyone needs to be aware that circumstances are going to change, and so many of us rush to get into as much house as we can qualify for,” Sullivan said. “Instead, try anticipating things like adding children to the family, dealing with a loss of a job or serious illness. Building in a bit of a cushion is a good idea, but we seldom do it.”
“Consumers need to be prepared for a highly regulated and unfortunately highly complicated process,” said Cosgrove. “But if they take the right steps and work with the right people, buying and owning a home can be one of the best things for them.”
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