How to Build Credit to Buy Your First House

How to Build Credit to Buy Your First House

TL;DR Your credit is one of the three critical elements that lenders look at when you apply for a mortgage. Great credit can save you tens of thousands of dollars, while bad credit can hurt your ability to get a loan. Mortgage lenders use a unique mortgage credit score, which means for first-time homebuyers it pays to track and build that specific score.

- Stephen Freudenberg, Head of Homeownership @ Gravy

“Perfect is the enemy of good.”

There is nothing wrong with chasing excellence – except when it unnecessarily holds you back. Yes, this is an article about credit scores, but it’s true!

You may believe you need an 800+ score to buy a house. That is false. You may believe you are years away from having a credit that would qualify you for a mortgage. Don’t count yourself out so fast!

Good credit is a helpful boost on the path to homeownership, but if you’re just in the “okay” camp, or maybe even the “bad” range, there are real actions you can take – today – to quickly flip the script.

The vast majority of people don’t have perfect credit, yet millions are homeowners. There’s a path forward for you too, no matter where you fall in the credit score range.

Why credit matters for a mortgage

Credit scores matter for a mortgage for two reasons.

1. The higher your credit score, the more loan options you’ll have.

2. A better credit score means lower interest rates.

A lower credit score, however, can limit your mortgage loan options, and if you do get approved, your interest rates could be astronomical.

Here’s how a better credit score can save you tens (or even hundreds) of thousands of dollars on your mortgage:

30-Year Fixed-Rate Mortgage Payment – $400,000 Loan Balance Note: Interest rates as of 5/23/2022. Source: FICO.

First, take a look at the monthly payment. With a 620 score, you’re paying $400 more a month for the same house and the same mortgage balance as someone with a 760 score. That adds up.

Next, look at how much more you’ll pay over the life of the loan. Sure, maybe you won’t stay in one house for 30 years, but the projections are intense – you’ll pay almost $150,000 more in interest over time, even though the difference in the interest rates is less than two points.

Finally, notice that once you hit 760, there’s no change in the interest rate you’ll get approved for – for the most part it’s all the same past that point.

What’s the minimum credit score needed to buy a house?

The credit score scale ranges from 350 to 850, and the average person is between 670 and 740. 90% of mortgage borrowers are above 670, which is a great target.

That said, for a conventional loan (the most popular type of loan), you may only need a 620 credit score to qualify. In addition, many first-time homebuyers can qualify for other types of loans, such as Federal Housing Administration (FHA) loans. For an FHA loan, you can have a score as low as 580, but still, interest rates will be much higher and it can be difficult to get approved.

No matter what, higher scores are better, because it means more options, and lower rates across the board.

Even improving your score 20-40 points can mean hundreds of dollars off the total cost of your monthly mortgage payment. It’s worth your time and effort!

It’s not just about your score

Before you go gung-ho on improving your credit and hope that’s all your mortgage lender will need, make sure you know the full spectrum of what any lender is going to look at.

There’s an acronym called ICE: Income, Credit, Equity. This is the formula lenders use to determine if you’re a good candidate for a loan. Here are the questions they’re going to ask in every category:

Income:

• Do you have a well-paid, steady, W-2 job? Are you self-employed? How many hours do you work? What is your monthly gross income? How long have you been at the job?

Credit:

• What is your credit score? If it’s low, what is pulling your score down? Do you have any major past issues like a bankruptcy?

Equity:

• How much do you have saved for a down payment?

These are the three financial categories you can work on to make yourself a better prospect for  a home loan. Credit is just one piece of the pie, but it’s an important one.

What goes into a credit score?

Before you dive into credit improvement mode, you should know what the credit score number is actually telling you, and how the credit bureaus calculate it.

Payment history

Without a doubt, the most important factor that affects your credit score is your history of on-time (or not) payments. If you think about it, your past behavior is likely the best predictor of future behavior when it comes to paying bills – at least in the eyes of a lender.

Your track record of paying back debt will determine whether they think it’s safe to offer you new debt. This makes up 35% of your credit score.

Credit utilization ratio

How you use your current lending limits is the next most important factor. This ratio is calculated by dividing the amount of revolving debt you’re carrying by the sum total of all of your credit limits. This is commonly referred to as your credit utilization ratio.

For example, let’s say you have two credit cards, one with a $5,000 limit and one with a $10,000 limit. Your total credit limit is $15,000.

If you have a balance of $3,000 on the first card, and $6,000 on the second, your credit utilization ratio is 60% ($9,000 divided by $15,000). That’s considered a high credit utilization ratio.

You should target having a credit utilization ratio of 30% or less. Otherwise, that’s a red flag to lenders. This accounts for 30% of your credit score.

Credit history length

Third, lenders want to know how long you’ve had your current accounts open. A very short credit history means there is not a lot of data to go off, so it’s not as easy to consider you a safe bet, even if your short credit history is positive.

Length of time you’ve had your accounts open is 15% of your credit score.

Credit mix

You’ll get a better credit score when you have a variety of account types under your name. A car loan, a student loan, a credit card – this is a better sign than if you only have a slieu of credit cards.

Credit mix counts for 10% of your score, which means there is usually no need to open up new accounts simply to improve your mix.

Credit inquiries

Apply for multiple credit cards lately? That’s going to ding you a bit. The number of times there is a hard inquiry on your credit report will count against you when it comes to your score.

This makes up 10% of your score. FYI: Checking your credit report does not impact your score if you get it directly from a credit bureau or use an approved tool like Gravy.

What is a mortgage credit score?

There are at least a dozen different types of credit scores and scoring models, and each serves a different primary purpose.

Applying for a credit card? A lender will probably check your FICO 8 score.

Just keeping an eye on your credit profile with Credit Karma? That’s a VantageScore 3.0.

If your goal is to qualify for a mortgage and buy a house, however, almost all lenders use FICO scores 2, 4, and 5 (together, the mortgage credit score). These scores are similar to, but fundamentally different from, a VantageScore or even a FICO 8.

The mortgage credit score is specifically designed to help lenders underwrite mortgages.

Each score is based on a different scoring model, and in some cases, the difference between your mortgage credit score and other scores can be significant. For example, reporting positive rent or utility payments to the credit bureaus does not help your mortgage credit score, but will boost your VantageScore.

As a result, it is critical for aspiring homebuyers to understand and track the right score so they are in the best position to get approved and save money on their mortgage.

Want to check your mortgage credit score? Get Gravy+ to track your FICO 4 score, based on data from TransUnion. We’ll show you a breakdown of the factors impacting your mortgage credit score and offer personalized suggestions for how to build your credit.

The top 3 credit issues that could derail your homebuying plan

What are the biggest issues you should watch for when it comes to your credit?

Credit issue #1: Paying bills late

Late payments are a big no-no. If you struggle to remember your due dates, take advantage of automatic bill pay options. Set calendar reminders. It may even be helpful to have a once-a-week financial check-in with yourself and ensure you’re on track with all your payments.

Paying bills on time, every time goes a long way towards making you an attractive prospect for a mortgage.

Credit issue #2: High credit utilization rate

That credit utilization ratio can kill the vibe quickly in a mortgage lender’s office. And it’s something that’s totally in your control to fix. Figure out if this is affecting your credit score, and pay down each account until the ratio on each is under 30%.

In fact, a better rule to live by is avoiding carrying a credit card balance altogether. The interest is expensive, and it can definitely hurt your score. Paying off credit cards is a good first step towards being mortgage-ready.

Credit issue #3: Collections and bankruptcy

The biggest pitfall on a credit report is having a bill go to collections. You should avoid collections and bankruptcy at all costs.

If you are (or have been) in a situation where you’re concerned you will not be able to pay a bill, don’t avoid it, and don’t simply not pay it. Instead, proactively call lenders to work out a plan before the bill goes past due. Most lenders will work with you on a revised payment schedule to make sure you’re able to pay back what you owe.

3 actionable things everyone can do to improve their credit score

There are things that prospective first-time homebuyers can and should do proactively to avoid the major credit issues that commonly affect mortgage applicants. There are also things you can do after the fact, if your credit isn’t where you want it to be, that can quickly have a corrective effect. Here are three ways to get started today:

#1: Ask for credit limit increases

Besides strategically paying down your accounts to get your utilization ratio under 30%, you can help the rate even more by increasing your total credit limit.

The wrong way to do this: apply for new credit cards. This will count as a hard inquiry and your score will dip for the next three months.

The right way to do this: ask your current credit card company for an increase on your credit limit. If you have a strong history of paying on time, this will likely be granted!

#2: Find and fix credit report errors

Every year, you can request a free copy of your credit report from each of the three credit bureaus: Equifax, TransUnion, and Experian. Go here to do that.

See any errors? Maybe a lender falsely reported a payment overdue or delinquent, even though you paid.

You can contact the credit bureau and have the error removed, as long as you show documentation of why it’s wrong, and follow the right procedure. They have 30 days to investigate and determine whether it’s truly an error.

Here’s more information about how to dispute a credit report error.

#3: Do not close old accounts

Look at your credit report and figure out which accounts you’ve had open the longest.

Whatever you do – don’t close these accounts. Even if you never use them anymore, keep them open. Remember, average account age represents 10% of your score.

Mortgage application tip: Once you've been pre-qualified and/or have a house under contract DO NOT open new lines of credit -- it's a way too common occurrence where someone opens a new credit card or leases a car before they close on a house and their entire mortgage application needs to be updated.

Can reporting rent payments improve credit?

Rent payment reporting services offered by property managers or companies like Chime do not improve the mortgage credit score – same with services like Experian Boost that report utility payments and other bills.

You can however, for free, ask your lender to look at the last 12 months of your rent payments when you apply for a mortgage. It can only help your case, so always ask. All you need are your bank statements showing proof of rent payment.

Unfortunately, missing rent payments and never paying them back (especially if they were sent to collections) can negatively impact your mortgage credit score.

How long does it take to improve a credit score?

The good news: the longer a negative event stays on your credit report, the less it matters. The bad news? It can take a while for them to fall off completely.

Bankruptcy: 7-10 years
• Late payment: up to 7 years
• Foreclosure: 7 years
• Collections: up to 7 years

But there are other ways to quickly see a positive effect. Correcting a mistake on your credit report could take as little as 30-90 days. And by lowering your credit utilization ratio on existing credit lines – you’ll see an effect in the next couple of billing cycles as those changes are reported to credit bureaus.

The bottom line: know where you stand today, because ignorance is not bliss. Until you know the issues with your credit score, you won’t know what to do to fix them.

Check out Gravy to see the same credit score that mortgage lenders use and get all the tools you need to become mortgage-ready.

Stephen Freudenberg
Stephen Freudenberg
Head of Homeownership at Gravy
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