How to Clean Up Your Credit to Buy a Home
After months of nonstop looking, you found your dream home and the seller accepted your offer. Then the totally unexpected happened: your lender denied your mortgage loan application because of a less-than-stellar credit score.
Somewhere between shock and embarrassment came a realization: A lousy credit score isn’t just a number, it’s the push that slams doors in your face.
Fortunately, there are clearly defined steps you can take to rebuild your credit after being denied a mortgage:
- Ask the lender for a letter explaining why you were turned down
- Check your credit report for inaccuracies
- Take steps to improve your credit score
- Improve your debt-to-income ratio
Rebuilding credit can take time and self-sacrifice, but as your score rises, so too does your ability to borrow money on friendly terms. Nearly everyone can improve their credit if you face the challenge and have a plan.
Many Mortgage Applications Rejected
According to the Federal Reserve Board, there were about 14 million mortgage applications in 2016 and 8.4 million originations, meaning 60% of the applications were approved.
Seen another way, that means 40% of the people who applied, didn’t receive a mortgage.
If poor credit torpedoed your loan application, you need to learn how to clean up your credit to buy a home.
First you need to find out why the mortgage lender turned you down. For most people, the reason is either an income that is too low relative the amount they want to borrow or a loan request that is too high based on the appraised value of the house.
If either one is your problem, fixing your credit isn’t the answer. You either need to increase your income, make a larger down payment or find a house that appraises for no less than you offered.
But poor credit can be a stumbling block. Ask the lender if your credit score was the cause of your rejection? If poor credit is the culprit, it’s time to focus on credit repair for mortgage approval.
Repairing Your Credit Score
To undertake credit repair for mortgage approval, you need to start with the basics. You might think that buying a house and using a credit card for routine expenses are two very separate subjects, but they are very much connected. If you don’t pay the monthly tab for those credit cards, it probably will be hard to get a mortgage.
Consumer credit, the kind attached to credit card, requires discipline. Only buy what you can afford, and pay your bills on time. Racking up too much credit card debt or not paying at least the monthly minimum balance on time, will bring down your credit score, and a poor credit score tells mortgage lenders you are a risk for a home loan.
One of the most important ways to maintain good credit is to not fall behind in repaying loans or credit-card debts. Your repayment history accounts for a whopping 35% of your credit score, so make payments on time. Late payments lower your credit score. Worse still, if a lender files a lawsuit to collect on delinquent debt, your score will suffer even more. Late payments, liens, foreclosures and bankruptcies can be highly damaging and can linger on your credit report for 7-10 years
The most important step is to carry no more debt than you can afford. You must always pay the monthly minimum payment on a credit card, but the goal should be to eliminate any balance on a card by the end of a billing cycle.
High interest rates are attached to almost all consumer debt. Credit cards typically charge annual interest (APR) of 15% to 30%. The lower your credit score, the higher that interest rate is likely to be. The best strategy before taking on more debt is to pay down your credit card balances.
The rating agencies compare the combined spending limits on your credit cards with the amount of credit you are using. That comparison, called your credit utilization ratio, accounts for 30% of your credit score. So even if you are paying your bills, your credit score can suffer if your credit utilization ration climbs above 30%.
Ideally, you would keep your credit card balances below 15% of your borrowing limits to avoid problems with your ratio.
Here are several other strategies to consider for raising your credit score:
- Become an authorized user on someone else’s credit card. An authorized user is someone who has permission to make charges on a credit account. Typically, a close friend on family member might add you to their account, but make sure the account has been open for a few years without late payments. Once you are on the account, its history will become part of your credit report. That could boost your credit score as much as 30 points.
- Build a credit history if you don’t have one. To get a mortgage loan, you need to convince a lender that you’re a good risk. If you lack a credit history, it’s hard to make that case. If you don’t have one, get a credit card. If you can’t get a standard card, apply for a secured card. You can also apply for a secured lump-sum loan, sometimes called a credit-builder loan, and repay it on schedule. Demonstrating that you can manage borrowed money is something lenders focus on.
- Have late payments removed from your credit history. Mortgage lenders frown on late payments on any reported debt. Creditors won’t always agree to take late payments off your report, but if they do, it will improve your credit score. Contact your creditors to see if it’s possible.
- Increase your credit limits. If you’ve been successful building your credit score and your income is sufficient, lenders might agree to raise the credit limits on your card. The higher your credit limit, the lower your utilization rate will be, even if your balance is unchanged.
- Keep accounts open. It’s better to keep a credit card unused in a strong box than close the account, even though you don’t plan to use it. Closing accounts can actually hurt your credit score in the short run.
- Check your credit report for errors. The three credit-scoring agencies must provide one free report detailing how your credit score was derived once a year. You should review the report for errors
that might have lowered your score. Look for things like incorrect payment statuses or fraudulent charges that might have resulted from identity theft.
The lower your credit score, the higher you mortgage interest rate will be, assuming you qualify for a mortgage at all. Those low fixed-rate mortgages you see advertised are reserved for applicants with high credit scores and aren’t available to you if your score is less than stellar.
Understanding the Mortgage Approval Process
Mortgage lenders use check lists to determine if you qualify for a loan. If you have defaulted on a mortgage in the last seven years, that can scuttle your application for a new loan. Even being more than 30 days late on a loan payment in the past year can be disqualifying. Knowing the rules in advance can save you grief.
Debt-to-income ratio is another key factor used in reviewing loan applications. Simply, debt is the sum you have to pay each month on borrowed money – cars, mortgages, minimum credit cards payments, personal loans, etc. Income is all the money coming in from salaries, rental property, investments, child support and any other regular sources.
Lenders look at two forms of debt-to-income-ratios. One, called the housing ratio, also called the front-end ratio, is the percentage of your income that goes to housing expense. Those expenses include mortgage payments, taxes, home insurance, association dues, etc. That ratio typically shouldn’t exceed 28%, but can be as high as 31%. The other, called the back-end ratio, is the overall debt-to-income ratio, which compares all debt payments to all income. Lenders consider under 35% ideal, but sometimes will allow ratios as high as 45%.
Those limits apply to conventional mortgage loans. The Federal Housing Administration (FHA) offers mortgages somewhat laxer requirements.
What if you think you’ve done everything right and your mortgage loan application is rejected anyway?
You are entitled to an explanation from the mortgage lender under the federal Equal Credit Opportunity Act. The law prohibits lenders from denying you credit if you qualify. If a lender turns down your loan, it must give you a letter explaining why you were rejected. You know your credit history and your credit score before applying for the loan. If the lender’s explanation doesn’t jive with that information, you have the basis for a complaint.
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NA, ND. What Protections Do I Have Against Credit Discrimination? Retrieved from: https://www.consumerfinance.gov/fair-lending/
Da Costa, P. (2011, July 11) Why Debt to Income Matters in Mortgages. Retrieved from: https://www.bankrate.com/finance/mortgages/why-debt-to-income-matters-in-mortgages-1.aspx
Graham, K. (2015, March 19) Turned Down for What: Rebuilding Your Credit After Being Denied a Mortgage. Retrieved from: https://www.quickenloans.com/blog/turned-down-for-what-rebuilding-your-credit-after-being-denied-a-mortgage
Burge, M. (2016, Oct. 8). How your credit score affects your mortgage rate. Retrieved from http://www.latimes.com/business/la-fi-credit-scores-20161009-snap-story.html
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