If you’re eager to move into your dream home, preparing your credit for a mortgage approval should definitely be on your agenda. Laura gives six tips for building credit before you apply for a mortgage, so you get a loan that costs as little as possible.
Tip #4: Reduce your credit utilization
Canceling an account could significantly reduce your available credit, which would cause your credit utilization to skyrocket and your scores to go down.
I mentioned that your payment history is one of the most important factors in the calculation of your FICO credit score. Paying your credit obligations on time is a powerful way to boost your credit, so never let any bill slip through the cracks—especially when a mortgage may be in your future.
After payment history, your credit utilization is the next essential factor to watch. This is the percentage of your available credit in use.
For example, if your credit card has a $10,000 line of credit and you have a $5,000 balance, your utilization is 50%. The optimal credit utilization is about 20% or less. So paying the balance down to $2,000 would result in quick boost to your credit scores.
Another important strategy is to avoid closing any credit accounts before getting a mortgage. While it might seem like having fewer accounts would make you appear more attractive to a lender, it can actually work against you.
Canceling an account could significantly reduce your available credit, which would cause your credit utilization to skyrocket and your scores to go down. So play it safe and wait until after you move into your new home to close unwanted accounts.
Also, having a mix of revolving accounts—like credit cards and lines of credit—and installment loans (such as auto, personal, or student loans) helps your credit. If you close all your credit cards, that could negatively affect your scores. To have the highest scores you need to have both types of accounts with positive payment history.
Remember that even a small drop in your credit scores could put you in a lower bracket that results in a higher interest rate, costing you tens of thousands of additional dollars over the life of your mortgage.
Tip #5: Cut your debt-to-income ratio
Having great credit won’t get you approved for a mortgage if your debt is out of control. Lenders use a formula called your debt-to-income ratio or DTI, which shows how your housing expenses and your total monthly debt obligations stack up against how much you earn.
The housing, or front-end, ratio shows what percentage of your income would go toward your expenses such as a monthly mortgage payment, property taxes, association dues, and home insurance.
The total, or back-end, ratio shows what percentage of your income would go toward all your debts, like a mortgage, car loan, student loan, and credit cards. For example, if your all your monthly obligations total $25,000 and you earn $50,000, your back-end DTI is 50% ($25,000 / $50,000 = 0.5 = 50%).
Common DTI thresholds are 25% to 28% for housing and 36% for total debts. If you exceed these, you may need to pay down some debt in order to get approved for a mortgage or to reduce your interest rate.
However, depending on variables like your credit score, down payment, and type of loan, you may get approved with higher ratios.