Credit can be a wonderful thing, but, too much of a good thing can backfire on you. For prospective homeowners, loan approval relies more on your history of debt repayment than on your income or savings.
How do you know if your credit history is healthy? Don't rely on guesswork. Order a copy of your credit record, preferably three months before applying for a loan. You'll see where you stand and have time to clear up any errors which may appear in your credit records.
How is credit risk measured? In today's lending market, most credit reports are automated, relying on a credit "scoring" system that analyzes about 100 variables to gauge the likelihood that the borrower will make on-time payments.
The information measured is gathered from retailers, public records, and sometimes credit applications and bank records. The score analyzes patterns over time, with more recent payment and debt habits holding greater weight.
In the scoring system used by Fair, Isaac—the originators of scoring software—the main criteria and their approximate percentage of importance are:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit—a warning of taking on too much debt (10%)
- Types of credit in use (10%)
Lenders use these credit scores, which range from 400 to 900 points, along with information such as the stability of your income, your employment history, and the value of any collateral and liquid assets, to determine your credit risk.
The lender then assigns you a grade from A to D, A being the lowest risk and D the highest. You may receive an "A" rating even with a past bankruptcy. Although 10 percent of homeowners have credit problems, 95 percent of mortgage applicants receive an A or A– rating. You may even qualify for a nonconventional loan with a B, C, or D grade, but expect to pay a higher interest rate.
These tips will help you establish and maintain a healthy credit history:
- Open an account. The only stumbling block as serious as poor credit history is no credit history. To receive an automated credit scoring, you must have at least one account that's been open longer than six months and shows activity within the past six months. To establish credit, start by requesting a credit card from your bank; that will trigger other offers.
- Don't go crazy on credit. Don't rush to open multiple accounts just so you can pay them off to raise your credit rating. Too many credit applications may be seen as a sign that your finances might be overextended. Applying for new accounts actually lowers your rating, since it lowers the average length of your account history—and, especially if you're new at using credit, it signifies risky behavior.
- Pay down before saving up. Lots of savings or a high income may help you with a down payment, but if your credit history is questionable, you'll be lucky to reach that point. Lenders want a track record of responsible debt payment—that's how they make their living. Make a habit of paying your bills, preferably in full but always on time. Paying down debts also saves you more on each dollar by reducing high interest payments.
- Minimize credit checks. Whenever someone requests your credit report, it appears in your credit history. According to Fair, Isaac, you can order copies of your own report from credit reporting agencies without worry; they even advise that you do this annually to check its accuracy, especially before a large purchase such as a house or car. But it could be a red flag if too many loan officers, credit card companies, or car dealerships are requesting your credit record.
- Don't take it to the limit. Lenders are wary of too many credit cards, but a bigger warning sign is even one account that's maxed out; they see it as a sign that you're overextended. The ideal is to use only one or two cards with medium balances that you pay on time (remember, promptness is more impressive than full payments). On the other hand, if your debts reach the limit on one or two cards it's better to redistribute lower balances over several accounts.
- Hold off on purchasing big "toys." Lenders like low debt, so unless yours is very low, hold off on charging a car, a boat, appliances, or large furniture until after you've closed on a new house.
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Fast Facts & Tips
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LIBOR (London Interbank Offered Rate) is the interest rate charged among banks in the foreign market for short-term loans to one another. A common index for ARM loans. |
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