by Matt Frankel, CFP | Dec. 2, 2018
If you're thinking about buying a home, here are five tips to boost your credit score and get the best interest rate possible.
You may have heard that you don't need excellent credit to buy a home, and that's 100% true. You can get a conventional mortgage with a FICO® Score as low as 620, which is generally considered to be "fair" credit, and you could get an FHA mortgage from a lender with a score lower than that.
Having said that, a higher credit score can mean tens of thousands of dollars in savings over the life of your mortgage. Here's a look at the current average mortgage rates by credit score, and how much interest you could end up paying on a $200,000 30-year fixed-rate conventional mortgage loan.
|FICO® Score Range||Average APR as of 9/6/2018||Monthly Payment on $200,000 Mortgage||Total Interest|
Data source: www.myFICO.com
To be clear, the FICO credit scoring formula is a closely-guarded secret. In other words, there's no way to accurately determine the impact of any specific credit behavior, such as paying off a credit card.
However, we do know the basic structure. Your FICO® Score is made up of information from five weighted categories of information:
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With these categories in mind, here are a few suggestions if you are thinking of applying for a mortgage in the near future.
As you can see, the amounts you owe on your various credit accounts is the second most important category in your FICO® Score.
Rather than focusing on the actual dollar amounts you owe, this category takes into account the relative amounts of your debts. In other words, how much of your revolving accounts are you using relative to your credit limits? How much do you still owe on installment loans relative to your original balances?
Credit card debt, especially if yours is more than 30% or so of your available credit, can have a particularly negative effect on your score. So, if you are planning to apply for a mortgage soon, paying down your credit card debt as aggressively as possible is one of the quickest ways to boost your credit score.
This isn't as much of a score boost as it is a way to prevent your FICO® Score from going down. As you can see in the FICO formula, new credit accounts for 10% of your score. This includes your recently-opened credit accounts as well as the times you've applied for new credit (also known as "inquiries") for the past 12 months.
While the FICO® Score drop from opening a single new credit account is likely to be just a few points, every little bit helps when trying to get the best interest rate possible on your next mortgage.
This is a common credit mistake people make when trying to improve their credit scores. It may seem like closing some of your unused credit lines might be a positive catalyst. After all, if you reduce the amount of credit available to you, doesn't that make you less likely to get yourself in over your head in debt?
However, closing credit cards can actually have the opposite effect. There are two main reasons.
The first is that by reducing your overall credit limit, your remaining credit card balances will represent a greater percentage of your available credit. For example, if you owe $2,000 and you have four credit cards with combined limits of $10,000, you're using 20% of your available credit. If you close one of the cards with a $2,000 limit, your credit usage jumps to 25% of your available credit, even though your debt remained the same.
In addition, if you close accounts you've had for a long time, it could hurt you in the "length of credit history" category as well, which makes up 15% of your FICO® Score. Among other things, this category considers the ages of each of your accounts and the average age of all of your accounts. So, closing older accounts can reduce your average and hurt your score.
This is the most obvious thing you can do to maintain and gradually improve your credit, but since your payment history is the single most important component of your FICO® Score, it's still worth mentioning. There are few easier ways to ruin your homebuying ambitions than accidentally missing a payment on one of your credit accounts. Even a single late payment can cause your score to plunge by 100 points or more if you have excellent credit.
We've already discussed that the "amounts owed" category is one of the most important factors in your FICO® Score, and that paying down your debts can help you maximize this portion of your score.
Similarly, there's another less-obvious way of reducing your credit utilization -- simply call your credit card issuers and ask for a credit line increase. In many cases, you can do this online with a few clicks of the mouse.
Here's why this can work. Let's say that you owe $1,000 on a credit card with a $2,000 limit, so you're using 50% of your available credit. If your credit line is increased to $4,000, your utilization percentage immediately drops to 25% without paying off a dime of your debt.
To be clear, it's still a smart move to pay off credit card debt as aggressively as possible, both for increasing your FICO® Score and for your overall financial health. However, asking for a credit limit increase can give you an extra boost.
Chances are, interest rates won't stay put at multi-decade lows for much longer. That's why taking action today is crucial, whether you're wanting to refinance and cut your mortgage payment or you're ready to pull the trigger on a new home purchase.
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