When you apply for a mortgage, the most important factor banks examine is almost always your credit score. That's why, as you head into the home-buying process, it's important to know your score and take some simple steps to raise it.
It's not actually that hard for most people to increase their scores. It just takes planning, and it's always better if you start early -- even a year before you plan on applying, if possible -- but you can still make big changes just a few months out from starting the mortgage process.
Start by knowing your score
Your credit score is a number that is generated based on your credit history. It's an indication to lenders and landlords of whether you are a credit risk and how much credit you can be trusted with.
Before you can fix your credit, it's important to know your credit score. Many banks offer a monthly credit score update to credit card customers. If yours does not, you can get your score from a number of websites, including myFICO and Free Credit Report. For a fee, each of these services can provide you with your credit scores and credit reports from all three of the major credit bureaus (Equifax, Experian, and TransUnion).
If you'd rather not spend money to get your credit score, then Credit Karma offers free credit scores from Equifax and TransUnion, though it doesn't provide your Experian credit score. It also provides minimal tools to help you manage your finances and improve your credit.
It's also worth noting that there are a lot of agencies out there offering to help you repair your credit. Some are credible, and some are not, but there's no reason to use them: Odds are, you can improve your score yourself.
Here's how to improve your credit score
1. Look for negative items on your report and make sure they're correct. Now that you know your score, the best way to start improving it is to look over your credit report and find opportunities for improvement. Once per year, you can get a free three-bureau credit report from AnnualCreditReport.com.
Items in your credit history that can lower your credit scores include repossessions, tax liens, collection accounts, late payments, and the two biggest and baddest ones of all: foreclosure and bankruptcy.
Each of these negative items hurts you less over time and will vanish from your record seven to 10 years after it first appeared. However, if there's a black mark on your credit report that's incorrect, then you can appeal to the three credit reporting bureaus to have the item removed by drafting a letter citing all of the mistakes and providing documentation proving that they're wrong. Examples of bad items include on-time payments that were recorded as late and false charges resulting from identity theft or credit card fraud. Keep in mind that you should only take these steps if you're at least six months out from needing a mortgage -- or, ideally, a year or more -- because it takes time for any corrections you make to register on your report.
At times it is possible to have late payments resolved before they're reported to credit bureaus. Try contacting your creditor and either disputing the payment or asking them not to record it as late so that it does not reflect negatively in your credit report.
2. Lower your credit utilization ratio. A large portion (30%) of your credit score comes from the percentage of your available credit that you've used. This is referred to as the credit utilization ratio. NerdWallet recommends that you keep your credit utilization ratio under 30%.
You can lower your credit utilization by paying down existing debt and/or increasing your available credit. You can accomplish the latter by either opening new lines of credit or raising your existing credit limits.
3. Increase your available credit (if you don't have enough). If you have relatively little credit compared to your overall income, then you may want to take out a new credit card or increase your credit line on an existing card. But remember too many lines of credit can tempt you to spend more money and increase your debt. So you should consistently make your payments on time and prevent that credit card debt from piling up.
4. Lower your debt-to-income ratio. The debt-to-income ratio calculates your monthly debt in relation to your income. BankRate has an excellent model for calculating your DTI ratio. According to the Consumer Financial Protection Bureau, your DTI ratio should be no higher than 43% if you're seeking a mortgage, but the lower it is, the better.
5. Avoid unnecessary credit inquiries. Everything from changing cable providers to adding a car loan can involve a credit check. Having a lot of inquiries can lower your credit score and cause lenders to be concerned that you might be looking to borrow money too often. However, there are two types of inquiries, and only one will hurt your credit score.
A soft inquiry is a credit report check that will not affect your credit score. For example, when a prospective employer checks your credit history, when you check your history yourself, or when you seek pre-approval for a credit card, it's considered a soft inquiry.
A hard inquiry is made when you apply for a car loan, mortgage, or any other type of loan that requires you to give the lender permission to run an inquiry. These inquiries will more than likely affect your credit score.
Plan ahead, pay down debt
What it really comes down to is making sure you pay all of your bills on time. Before applying for a mortgage, try to cut out any loans you may have. Auto loans and other forms of recurring debt count against you when banks and lenders use their proprietary formulas to calculate how much you can borrow.
Lowering your debt and paying your bills on time can lead to a better credit score. It's not magic, but it does take planning. You can improve your score, but whether you plan on applying for a mortgage in a few months or at some unknown point in the future, the time to start preparing is now.