Establishing Credit Scores

If you’re a reader of Mortgage Porter, you probably know that I just returned from a long weekend to Nashville to visit my son and check out his new apartment. Getting started on your own is an important part of your life and it helps to have established credit. This is especially true if you plan to buy a home as most lender will require that you have three to four established accounts. The credit lines you establish (and other credit events) will determine what your credit scores are.

An “established tradeline” is typically a credit account with at least 12 months payment history. It’s ideal if the account is actively used has a low balance. Although paying off and closing accounts is a financially wise thing to do, if you’re trying to build your credit or getting ready to buy a home, it actually may lower credit score. This is because current credit scoring modules are looking to see active credit usage. There are no extra points for paying things off early or closing or not using your account.

I have had clients who come to me thinking they were ready to buy a home because they paid off their debts and closed there accounts. Common sense to you and me would think they’re a great candidate. However, their credit scores would probably not accurately reflect that. Before you pay off any accounts or make any changes to your credit, please check with your mortgage professional if you’re considering buying a home in the next two years.

Here’s the advice I would offer someone like my son, who is getting ready to build credit.

• Check your credit report. You may not have anything reporting on your credit, or you may be surprised to see collections from a parking ticket, overdue library book, or medical bills, just to name a few. If you find you have derogatory items reporting against you, it’s important not to dispute them if they really are your debts. Although it will temporarily help your credit score, in most cases, mortgage lenders will require the disputes be removed which will cause the credit score to dip back down. If you pay off a collection, make sure you keep records of it. Before you pay off a collection, contact your mortgage loan officer. Some collections may not have to be paid off. You can obtain a free copy of your credit report at www.annualcreditreport.com .
• Get a credit card with a low balance and use it for even smaller purchases. Credit scoring favors low usage of credit. Keep the balance below 30% of the credit limit. For example, if your credit card has a limit of $200, try to keep it below $60 and pay it off monthly.  I recommend getting a credit card as soon as possible to work on establishing credit. Start with one card and after a few months, if you’re comfortable with the payments, add one more and apply the same principal.
• Pay your debts on time (if not early). If your payments are late, then you are establishing credit… just not the type you want.  A late payment on your credit report may impact your scores for quite a while. The only thing that can reverse a late payment on your credit report is time. Your score will slowly improve as you demonstrate you can make the payments on time. If you are not in a position to pay for a monthly credit card, wait until you are.
• About those student loans. Current underwriting guidelines require that a payment be factored for qualifying purposes even if student loan payments are deferred. Student loans are factored into your credit scores and can help establish credit. Credit scores receive the most improvement at 50% and 30% of the credit limit regardless of how big the loan is. For example, a loan with an original amount owed of $20,000 paid down to $10,000 has the same impact as a loan with an original balance of $2,000 that is paid down to $1,000. You may want to start making larger payments towards your smaller student loans to get below that 50% credit limit point and, of course, make regular scheduled payments on  your larger student loans. Again, please review your scenario with your mortgage professional.
• Don’t pay cash for everything. As you’re building your new home, for example, buying furniture. Consider financing it if a low or zero interest is offered. Be aware that these offers are often for a limited time – so I recommend that you only do this if you have enough cash in savings to pay off the furniture (what ever the debt is).  The goal with this debt would be to pay it down to 50% of the credit limit as soon as possible, then work towards getting it down to 30% of the original credit limit AND doing this before the interest rate on the debt jumps higher. Let’s say you need to buy a new mattress and it cost $1,000 and you have $1,000 in savings. It’s really tempting to plunk down $1,000 and avoid the debt. If you have employment, can afford the payment and the mattress sales company is offering low or no interest for 12 months, consider financing the bed. This will help build your credit. Once you receive your first statement, start making payments – even if they’re deferred. This reminds me…
• “Same as cash…no payments due” offers hit your credit score too. It may seem like since it’s “same as cash” that it won’t impact your credit. However, it does. Often times “no payments due” offers will carry a higher interest rate once the “no payment” period is over. Make payments on these types of accounts regardless of the “no payment due” requirement.

A few tips not quite related to credit scoring…but helpful if you’re considering buying your first home in the next couple years.

• Savings are important to. Your checking and savings account does not impact your credit score, however, you will need some funds in savings (if you’re considering buying a home) for some down payment and closing cost. Lenders really like to see that you have at least two months of your proposed mortgage payment in reserves (savings after closing). Your retirement accounts can count as “reserves”. (If you’re newly employed, make sure you’re taking advantage of your employer’s retirement plans).
• Attend a home buyers class. Home buyer classes contain a wealth of information. Some (okay, most) are taught with the insturctors having great hopes of having you as a potential client. You don’t have to use the loan officer or real estate agent who teaches the class. Classes that are sponsored by the Washington State Housing Finance Commission (WSHFC) follow criteria required by the WSHFC and students are eligible for programs offered by the WSHFC, including down payment assistance programs. Before signing up for a home buyers class, you may want to research the instructors and check to see if it is WSHFC sponsored.

If you are in Washington state (where I’m licensed), I am happy to help you create a game plan to build your credit so you can be on right track to buy a home. It doesn’t matter if you are 6 months, two or five years away. You can’t start too soon on establishing credit.