Most people know that in order to get a mortgage, or any loan for that matter, they need to have decent credit. If they don’t, they will either be denied, or have to pay a higher interest rate.
Most people, though, know very little about what that means. Nor do they know what to do to improve their credit situation.
The whole field of credit building is very complicated. That’s why credit coaching is an integral part of our Rent 2 Own program. We take very seriously our role of helping people get their credit scores and reports up to an acceptable level for the banks to approve them for a mortgage.
Not everyone needs to know everything about it. But there are many basic things that aren’t that complicated, that can get you way ahead, if they only knew about them. And there are many myths out there, as well, that need to be debunked.
In this first of a series, I’d like to point out a few basic things that people should know about credit. In future posts, I want to add more detail and talk about some more technical things.
- Your credit score and your credit report are two different things, though the score is based the data that appear on your report. There are two main credit bureaus that collect personal credit data: Equifax and TransUnion. Both they, and other third party entities, have algorithms that compute a score based on the data supplied to them. The underlying data is stored for long periods of time; the score is dynamic, computed instantaneously when the request comes in.
Agencies that report to the bureaus (credit card companies and other lenders) usually report monthly, and usually within the first ten days of the month. Therefore, a new score is generated every month (or, in fact, every time any agency reports).
The algorithms are not identical, nor do all agencies report to both bureaus. Therefore, you will have several different credit scores. They are usually close, but not always.
- You can check your own credit scores from several different agencies. Some are free. When you check your own score, it is called a “soft hit” and it does not affect your score.
- You must have a credit card in order to get a mortgage. Some people come to me with the impression that using credit cards is bad and they can protect their good standing by paying everything with cash. Wrong! Without a credit card, you do not have good standing; in fact, you may have no standing at all.
How can a lender judge whether you are responsible with paying back a loan (a mortgage is just a particular loan), if you have never had the occasion to do that? A credit card, in the eyes of the lender, is the best barometer of that.
- A large amount of debt is not necessarily bad. Your credit is influenced not so much by the amount of outstanding debt you have but by the amount of debt you have compared to the amount you have been judged capable of handling. If you have $5000 left on a car loan that started out at $25,000, it shows that you are capable of handling a large debt and have been responsible in paying down most of it. But if you credit card shows an outstanding balance of $5000 on a card that has a $4500 limit, it suggests that you are irresponsible with money.
The first scenario will push your score up; the second will push it down.
- You need at least two “trade lines” (i.e., sources of credit) showing on your credit report in order to get a mortgage. At least one of these must be a credit card. It is okay if both of them are, but the second could be a vehicle loan, a retail loan or a bank Line of Credit.
- You must pay your bills on time every month. A late payment will not only hurt your score, but any late payment within the previous year may automatically disqualify you for a mortgage, regardless of your score. You do not need to pay off your outstanding debt fully, (though that is a good thing) but you do need to pay at least the minimum requirement each month.
- Never close a credit account! This is one of the biggest mistakes people make! Closing a card will instantly hurt your credit score. The long history you have with that credit line is lost when you close the account. It takes a long time for any replacement credit facility to build up that same valuable standing. If you no longer need a credit line or are replacing one type of credit card with another, just stop using the first one regularly but don’t close it. Even better, use the old one occasionally, just so that its good reputation is maintained in the credit bureaus’ algorithms.
- Get rid of bad things on your report, like Collections. These will have a huge drag on your score. Furthermore, the information will stay on your report for six years (from the time of last activity) so, though the drag effect may diminish over time, it will not go away. Get the six-year clock ticking as soon as possible.
- Time is a great healer/builder of credit. If you have had a credit card in good standing for ten years, it will have a bigger positive impact on your score than if you just opened it last year (see point 7). Likewise, if you have paid off a bad debt three years ago, it will have less negative impact than one you paid off last month (see point 8). Furthermore, if you want to get a mortgage, the two trade lines referred to in Point #5 must be at least two years old.
These basic tips are general ones. Everyone’s report is unique and there may be occasions to make exceptions to some of these guidelines. But, there are also many more things, besides these basics, that affect your report and scores. In future posts, I will share more details and guidelines.