As you’re probably aware, most lenders use the FICO® scoring system to assess a homebuyer’s creditworthiness. This so-called “credit score,” which ranges between a low of 300 and a high of 850, quantifies your risk of defaulting on your mortgage. While some people dismiss the importance of maintaining good credit, it has a significant impact on whether you get approved for a loan as well as the interest rate you pay.
If you’re looking to buy a house someday, it’s important to understand how lenders determine your score so you can keep a clean credit report before you apply for a loan.
Components of a FICO Score
The three major credit bureaus—Experian, TransUnion, and Equifax—calculate your credit score based on five components:
1. Payment History
This is the largest and most important component of your credit score. Have you made late payments on your credit card or student loans, or do you have a history of debt write-offs or money judgments? If so these things negatively impact your credit score and your eligibility for a home loan. In general, banking institutions look at your payment history as a tool to predict future behavior, so if your credit report shows that you’re bad at repaying your debt, then it may be difficult to get approved at a lower interest rate (if approved at all).
Tip: To maximize scoring in this category, be sure to make payments on-time and (if possible) in-full.
2. Outstanding Credit Card Balances
“Credit utilization,” or the ratio of your outstanding debt to your credit limit, is the next major component of your credit score. According to Experian, a high credit utilization rate (above 30 percent) is associated with greater risk because it’s deemed a sign of financial hardship, which means it’s probably not a good idea to max out your credit cards or to hold a balance that is close to your credit limit.
If you have a low credit score you can improve your creditworthiness by maintaining low credit card balances. The best scores, as reported by FICO, the agency who created the FICO scoring system, typically have a credit utilization rate of less than 20 percent.
Tip: Experian urges against closing your unused credit cards due to the risk of increasing your credit utilization.
3. Length of Credit History
Length of credit history looks at how long your credit accounts have been open in addition to the length of time since you made a recent purchase. Of course, this means a homebuyer with no credit history will score lower than a person who has a longstanding past of borrowing and paying off debt without missing payments.
Tip: Using a credit card for purchases and paying your bill before the due date can help you establish a clean credit history. Similarly, homebuyers who wish to maintain their current FICO score can avoid dormancy fees and untimely account closures by spreading out their debt to multiple cards rather than using one credit account.
4. Type of Credit
In the eyes of a lender, a diverse portfolio of credit means that a borrower is capable of managing various types of debt. Although this category of scoring holds less weight in comparison to payment history and credit utilization, FICO experts recommend keeping a mix of revolving credit (e.g. credit cards) as well as installment credit (e.g. student loans) for best financial health.
Tip: According to Jay Delgado, an author and specialist in restoring credit, most advisers recommend having one loan for every three to five credit cards.
5. Credit Inquiries
Credit inquiries represent the number of times you’ve applied for credit. A hard inquiry, such as applying for several mortgage loans at the same time, can actually hurt your credit score, whereas a soft inquiry (say, when you sign up for a cable provider) does not affect your score.
Tip: The Fair Credit Reporting Act (FCRA) requires the major credit reporting companies to provide a free credit report to you every year. To order your report, you can visit annualcreditreport.com or request a form here.
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