Ah, the credit score. This almost-mythical three-digit manifestation of financial responsibility is among the most important numbers in a person's life. Unfortunately, many of us are confused about how credit scores are formulated, what they affect and where we stand. That's a big problem, especially for potential home buyers.
Both consumer credit scores and the real estate market have improved in recent years from the doldrums of the housing collapse and ensuing recession. Not only are there fewer distressed homeowners these days, but we're also on pace for a 9 percent increase in annual home sales during 2014 as well as an until-further-notice continuation of Federal Reserve policies designed to keep interest rates low and stimulate economic growth.
"Current mortgage rates remain very attractive by historical standards, though they have climbed just over half a percent from the levels in 2012," Michael L. Bognanno, chairman of the economics department at Temple University, told WalletHub in a recent interview. "Because current inflation and expected future inflation are at low levels and unemployment, while gradually falling, remains high, I expect the Federal Reserve to continue the course of depressing interest to promote growth, employment and the recovery of the housing market."
In other words, even though home prices are on track to rise 11 to 12 percent in 2014, the current landscape is very appealing for consumers who have solid credit and the ability to place a sizable down payment on a home. Why are those factors so important? Because the higher your credit standing and down payment are, the better your odds of mortgage approval will be and the less you will pay when all is said and done.
%VIRTUAL-article-sponsoredlinks%For starters, people with good credit are in a position to save more than $2,000 per year on mortgage-related finance charges relative to those with bad credit.
Good credit will also help you save on mortgage insurance if you don't have the recommended 20 percent for a down payment. According to a recent WalletHub Study, low-down-payment applicants can save roughly $3,500 to $13,000 in just five years by opting for private mortgage insurance instead of a Federal Housing Administration loan, with the upper bounds for people with strong credit.
The question, therefore, is how to make sure your credit standing is ready for prime time. While much depends on your purchase timeline, there are a few steps that all potential homebuyers should take to prepare their finances for the big day.
Determine where you stand. There are a number of free ways to estimate your credit standing, and doing so will enable you to evaluate your starting point as well as develop a plan to improve your applicant profile if necessary.
Check your credit reports for errors and fraud. The National Consumer Law Center reports that research by consumer groups shows that up to 25 percent of consumer credit reports contain errors significant enough to cause a denial of credit. Finding unauthorized financial accounts listed on your credit report is also one of the easiest ways to spot fraud. And since we are all entitled to a free copy of each of our major credit reports once every 12 months, there's no reason not to make sure everything is in order before getting too deep into the home buying process.
Pay bills on time and minimize credit utilization. Payment history and amounts owed together account for roughly 65 percent of your credit score. Given that potential lenders are likely to be most concerned about recent performance, it's important that you pay all credit card and loan bills by the due date and use only a fraction of the credit made available to you in the months leading up to a home purchase.
Maximize savings. The bigger your down payment, the more you will save on a home purchase. That's obvious, since you'll be borrowing less, paying less in interest over the life of your mortgage and assuming full ownership of your home sooner. Making a budget that eliminates unnecessary expenses and maximizes savings should therefore be a no-brainer for anyone seriously contemplating buying a home, especially considering the added cost of moving and furnishing a new home.
Be strategic about opening a new credit card. Credit cards are the most efficient credit building tools available to consumers, as they report account information to the major credit bureaus monthly without necessitating that you get into debt (unlike a loan). As long as this information reflects timely payments and low credit utilization, it will lead to credit score improvement over time. But opening a new credit card account can diminish your credit score for a few months. That means it's wise to get a new card only when you have the better part of a year before your planned home purchase.
A home is one of the most important purchases that anyone will make in their lives. And much like you can't expect to do well on a big test without studying, you can't expect to buy your dream house and minimize the cost of the transaction without first making sure your financial house is in order. So give some love to those credit scores, squirrel away some savings and you'll take down that for sale sign in no time.
I was thrilled to pay off one of two credit cards last fall, and as of last week, I hadn't touched the thing. Then I got a letter from my bank, announcing a pretty incredible limited time bonus -- 5 percent back on travel-related purchases made by March 30. The bonus just so happened to be for the card I hadn't used in months. And it was no coincidence either.
We all know that red flags like late payments, too many lines of open credit, and a mountain of student loan debt can knock dozens of points off credit scores. But what about the little-known ways banks and lenders are judging us -- even those of us who are "low-risk" clients?
With help from Adrian Nazari, CEO of CreditSesame.com, here are five ways every credit customer is judged, whether they like it or not.
When lenders size up potential borrowers, they aren't just looking at how much they spend, but where they spend as well. If you've gotten a letter in the mail congratulating you on a freshly-inflated credit limit (or a new cash-back bonus like I did) chances are your lender has noticed you've been diligently paying off your card and selectively shopping where you can afford to.
"For example, if you normally shop at high-end stores and regularly pay off your card, and then suddenly start shopping at discount stores and carrying a balance, the lender could use this behavior data as an indicator that you have become higher risk and could take steps to minimize its exposure," says Nazari. "Alternatively, if your behavior data indicates you are a good risk but you aren't generating a profit, an issuer might determine how to incentivize spending."
How to improve it: Since Behavior Scores are based on triggers like long-term credit card activity, late payments, limit breaches, and fees, if you can figure out how to improve these, you'll be able to beef up your score.
FICO uses this score to help creditors find the "diamonds in the rough," says Nazari. "Those slightly higher risk prospects [who] have the potential to be highly profitable customers. In other words, this score allows lenders to determine how profitable you are to them and market to you accordingly, which could include offering you deals that incentivize spending."
How to improve it: There's not really much you can do here, Nazari notes. The revenue score just helps the lender tailor its marketing strategy to your specific needs -- and weaknesses.
Despite its title, this score isn't used to lower scores when consumers file for bankruptcy. Instead, it's a carefully formulated algorithm used to predict how likely they are to go bankrupt. "This score is usually generated when you open a new line of credit and you give the creditor permission to pull a credit report," says Nazari. "This score helps creditors assess and minimize their risk in advance, and allows banks, which are required by law to keep a certain amount of 'bad debt reserves' on hand, to lower that amount."
How to improve it: Nazari's advice: "Pay your bills on time, keep debt balances low, open accounts only when necessary to avoid excessive inquiries on your credit report, and monitor your credit report regularly to ensure it is accurate." Until recently, credit report monitoring has been a costly (and not entirely necessary) service for consumers. But now Credit Sesame and Credit Karma both offer the service for free.
Your credit score doesn't just drop when you have debts sent into collections. How likely you are to pay off those debts can determine whether collectors will harass you or not. "The lower your collection score, the less likely a debt collection agency is to aggressively pursue you because the agency doesn't want to waste valuable resources trying to collect debt that is unlikely to be recovered."
How to improve it. Simple: Don't let your debts go into collections. And if they have? Don't panic. Follow through with each phone call, ask if they are willing to negotiate, and keep a clean paper trail throughout. For unnecessarily aggressive collectors, don't hesitate to alert the CFPB or FTC.
If all this wasn't creepy enough, the attrition score is also known as the "Wandering Eye" score. It's how lenders decide how likely it is that you'll "cheat" on them with another competitor. "When this score is high, it tells lenders that they may need to sweeten the pot and offer you various perks so they can continue to make you happy and committed," Nazari says.
How to improve it. We're not sure you'd want to worry about this one. In fact, it could be good for you to make your lender a little jealous from time time. "You want your credit card issuer to think you might abandon them for a competitor so they'll work a little harder to keep you," says Nazari. "Calling your issuer to request lower rates or balance transfer information can let them know you might be in the market to make a switch. If you use your credit card regularly, another way to let them know they need to court you again is to simply stop using your card."