Are you planning to buy a new home this year? Unless you’ve recently won the lottery or can otherwise afford to pay in cash, it’s probably time to start thinking about how to prepare your credit for an upcoming mortgage application.
The condition of your credit reports and scores is never more important than when you’re preparing to apply for a new home loan. A mediocre credit score can cost you tens of thousands of dollars over the life of a loan. Even if your credit is already in decent shape, you could still potentially earn a better rate and save money each month by working to improve your credit before applying for a mortgage.
Don’t Go Blindly Into Your Application
First things first: You need to know what is currently appearing on all three of your credit reports prior to your loan application in order to avoid any unpleasant surprises. The good news is that checking your credit reports is easy and free. You can claim a free copy of your three credit reports once every 12 months online at AnnualCreditReport.com.
Once you’ve pulled your reports, it’s time to review them in careful detail. Errors on credit reports are not uncommon and it’s ultimately your responsibility to monitor your reports with all three credit bureaus (Equifax, TransUnion, and Experian) to ensure that they are indeed accurate. The only way to effectively monitor your credit reports for errors is to routinely check them.
If you do discover an item on your credit reports that doesn’t belong there, or if you find other incorrect information, you have the right to dispute those issues with the credit bureaus directly. You can submit disputes completely free of charge, or you can hire a reputable credit repair company to take care of the legwork for you (for a fee).
Which Balances You Should Pay Down?
Sometimes paying down the balances on your accounts can have a positive impact on your credit scores as well. However, all balances are not created equal when it comes to credit scoring. Credit card balance reduction is great, installment loan balance reduction isn’t so helpful.
Typically the most actionable way to improve your credit scores is to lower or, better yet, to completely pay off your credit card balances. A sizable one-third of your FICO and VantageScore credit score is largely based on your credit card utilization, also known as revolving utilization. The more of your credit limit you tap, the worse the impact will be on your credit scores. For this reason, paying down credit card balances is very likely to begin moving your credit scores upward, and quickly.
Paying down the balances on other types of accounts will not have the same positive credit score impact as paying down a credit card. For example, you could pay off a $5,000 balance on your auto loan or a similar balance on a maxed-out credit card, and you would almost certainly see a much larger score benefit from paying off the credit card account. In fact, paying off an auto loan might not help your scores at all.
If you have certain derogatory items present on your credit reports (collections, judgments, tax liens, etc.), your lender may also need these to be paid prior to closing. However, the benefit of paying off the balances on your derogatory items, while tangible, won’t be as profound as you may think.
- Related: Revolving Credit vs. Installment Loans: Why the Type of Account Matters to Your Credit Score
Avoid These ‘Classic’ Credit Mistakes
Be careful not to unknowingly sabotage yourself with classic credit mistakes prior to a new mortgage application. The two most common mistakes consumers make prior to applying for a mortgage are a) increasing credit card debt, and b) applying for or opening new credit accounts during the underwriting period.
Not only do Fannie Mae and Freddie Mac’s underwriting standards frown upon opening new accounts during the underwriting process, credit scoring models are designed to pay attention to how often you apply for credit and the “age” of your credit reports.
When you apply for credit, regardless of whether you are approved, you run the risk of a credit score decrease. Additionally, if you do open a new account, you’ll likely lower the average age of the accounts on your credit reports, which can potentially have a negative score impact. Add to that the problems you’ll cause by taking on new debt during the underwriting process, and how it can throw your debt-to-income ratios out of whack, and you’ll be better off not making these mistakes.