It's a well-known fact that applying for and opening new credit accounts can cause your credit score to drop, and a mortgage isn't an exception. However, the long-term credit score benefits of your mortgage will quickly outweigh any negative impact. Here are two reasons a new mortgage could hurt your credit score, and all the reasons you shouldn't worry about them.
The initial credit inquiry might cost you a few points
It's absolutely true that your credit score can go down if you apply for credit, including a mortgage. Ten percent of the FICO credit scoring formula is made up of "new credit" information, which includes credit inquiries. Inquiries that took place within the past 12 months, that you initiated, are included in the scoring formula.
However, it's not as bad as you think. While applying repeatedly for new credit can cause your score to drop significantly, a single inquiry is unlikely to cause a drop of more than a few points.
Furthermore, there is a special "rate-shopping" provision in the FICO formula that says that all mortgage-related inquiries that occur during a normal shopping period (generally defined as 14 days), will only count as one inquiry for scoring purposes. In other words, you can fill out mortgage applications with as many mortgage lenders as you want, and it will have the exact same minor impact on your credit score. This is an excellent strategy to find a lender who will give you the lowest rate, which can save you thousands of dollars.
And your score might go down a bit initially after you get the mortgage
The new credit category I mentioned in the previous section also includes newly opened accounts, which your mortgage will be -- for a little while.
In addition, 30% of your FICO score comes from a category called "amounts owed." Among other things, this category includes your loan balances relative to their original principal balances. When you first open your mortgage, the fact that you still owe 100% (or close to it) of the loan's original balance can potentially be a negative factor.
As a personal example, my wife and I bought our house in May 2015, and my credit score instantly took a 20-point dive. The effect on your score may vary, but the point is that a small drop is to be expected.
But a new mortgage will be a positive factor soon
That's it for the bad news. The good news is that your mortgage will help your credit score in virtually every way possible, either immediately or over time. To illustrate this, consider the five categories of information that make up your FICO score:
- Payment history (35%): This is the highest-weighted FICO score category, and basically rewards people who pay their bills on time. So, as you make your mortgage payments in a timely manner, this category will be positively affected.
- Amounts owed (30%): I already mentioned this as a potentially negative factor, at least when you first get your mortgage. However, as the principal balance of your loan begins to fall, it will help this category more and more.
- Length of credit history (15%): This considers such time-related factors as the age of your oldest credit account, the ages of your individual accounts, and the average age of all of your accounts. So, as your mortgage account gets older, it can boost this category as well.
- New credit (10%): The initial credit inquiry from when you apply for your mortgage will no longer influence your score after a year, and it won't take long until your mortgage is no longer considered a "new" account.
- Credit mix (10%): This is the category that can potentially be helped right away by getting a mortgage. The FICO formula rewards consumers who have a good mix of credit accounts – credit cards, mortgages, auto loans, etc. The idea is that this shows lenders that you can handle all types of credit responsibly. So, if you didn't already have a mortgage on your credit report, this could be an immediate positive factor.
The Foolish bottom line
There are several financial things you need to consider when buying a home, such as whether or not you can afford the payment. The impact to your credit score should not be one of these factors.
To be perfectly clear, your credit score may suffer a little when you first get your mortgage. However, any drop in your score is likely to be mild and short-lived. The long-term credit benefits of having a mortgage far outweigh the short-term downside potential, so don't let the fear of a credit score drop impact your homebuying decisions.
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