Credit Scores and the First-Time Homebuyer

For first-time homebuyers, the second most important factor (behind location) is:

            (A) Number of bathrooms.

            (B) Composition of the kitchen counters.

            (C) Storage space.

            (D) Terms of the mortgage.

If you answered A, B, or C, it’s time to switch the channel. You have been watching way too much HGTV.

But if you zeroed right in on D, congratulations. You, the federal Consumer Financial Protection Bureau, and virtually every real estate professional agrees.

In a blog post from early 2017 — which has had no need for updating, because it’s still the ironclad truth — the CFPB declared, “Choosing a mortgage to pay for your new home is just as important as choosing the right home.”

The right mortgage will go a long way toward determining how much you love your home three, five, even (if you stay that long) 10 years down the road — or if, instead, you resent your decision to stop renting and start owning because you’re straining under a burdensome mortgage.

What a Difference Your FICO Score Makes

“When you’re ready to buy your first house,” says Kelan Kline, half of the personal finance advice team TheSavvyCouple.com, “your credit rating is one of the most important factors in determining what you will pay for a mortgage.

“Your score reflects how likely it is that banks and lenders will feel like they can trust you to pay back any money you borrow.”

Kline has the situation nailed. Several factors weigh on how sweet a mortgage you can score, but all other things being equal, the dealmaker/breaker is your FICO credit score. In late 2021, FICO reported borrowing rates ranging from 2.576% for homebuyers with credit scores of 760 and above to 4.165% for those with credit scores 620-639. (Generally, 620 is the lowest score lenders will consider without some sort of government program underpinning the borrower.)

What that means in the real world: On a $300,000 mortgage with a 30-year fixed-rate term, that near-1.6-point difference means borrowers with the worst scores pay $264 more per month than those with the best ($1,461 vs. $1,197). Just boosting your score 40 points — say from 640 to 680 — can get your interest rate below 3% and shave more than $100 off your monthly payment.

Thinking of taking the first-time homebuyer plunge? Unless you’re one of the rare ones paying cash or relying on most-favored-nephew financing from a wealthy relative, be prepared for a close inspection of your financial life. Most likely, you’ll be asking someone who has to answer to supervisors who have to answer to bosses who have to answer to shareholders and federal regulators to lend you a big pile of money. Because they need to know you’re capable of keeping all those folks happy by paying them back, they won’t leave anything to speculation.

“Your credit score shows if you have been trustworthy as a borrower in the past,” says Windy City Homebuyer CEO Tomas Satas. “It guides a lender with their decision of how much they will be comfortable lending to you.”

Step One: Get Your Credit Report

Credit reports and credit scores, though closely linked, are not the same thing. The major agencies — Experian, Equifax, TransUnion — are the primary keepers of credit reports (that is, what’s been going on in your financial life), and from these credit (or FICO) scores are derived.

Your credit report tracks the type and number of accounts you have open, your payment history, your balances, and the ages of your credit accounts. From these, the Big Three use unique, proprietary formulas to assign a credit score.

Any lender that inspects your application for a mortgage will review one or more of your credit reports. You must know before the underwriters do what’s in there.

By law (and under normal conditions), the Big Three must — upon request — provide a free copy of your credit report once every 12 months. But wait! All three announced in August they would continue a program launched at the start of the pandemic — free weekly reports — through April 20, 2022.

Step Two: Look for, and Dispute, Reporting Errors

The Big Three are very good at what they do, but they are not flawless. In June 2021, Consumer Reports published findings that showed credit reports that “are rife with errors.” Of the nearly 6,000 volunteers who checked their credit reports for the study, 34% — more than one-third — found at least one error; 29% detected errors related to their personal information.

In a joint statement, heads of the three credit-reporting giants rejected the study’s findings, claiming their industry’s accuracy hovered in the range of 98%. However, a 2012 review by the Federal Trade Commission found 25% of Americans detected an error on their credit reports.

What’s a first-time homebuyer to do? President Reagan’s admonishment comes to mind: Trust, but verify. Get your credit reports and comb through them. You may find nothing amiss. Then again, you may find something materially incorrect.

To fix factual errors — you’re mistakenly down for a late payment, or maybe you’re showing a balance on a loan or credit card you’ve paid off — you must dispute them, in detail and with documentation, with each of the reporting agencies.

Provide your complete name and address; include the agency’s dispute form (if it has one), a copy of the credit report with the error(s) highlighted, and documents verifying your claim. Keep copies of all the records you deliver.

Step Three: Be Ready to Explain Your Credit History

If you’ve hit potholes along your financial road, be prepared to explain the circumstances that led to, say, a late payment, or that time you charged above your card’s credit limit.

Perhaps you can point out that your financial mishaps are rare, the result of outside forces, and quickly remedied. But you might be caught wrong-footed if you haven’t reviewed your credit report and you are asked about a financial mishap from two or three years ago.

Along these lines, first-time homebuyers may get a boost by shopping with someone who knows them, such as a credit union.

“Perfect credit isn’t necessary to get a loan,” says Michigan Legacy Credit Union CEO Carma Peters. “While a higher credit score is desirable, many consumers don’t realize that it’s also important to have a good relationship with your lender, should you experience financial challenges. This is especially critical for those who have a history of bad credit.”

Step Four: Develop a Strategy for Improving Your Score

String theory is hard. Improving your credit score is not. All that’s required is getting a firm grip on the five factors that influence the numbers:

• Payment history (35%)
• Ratio of account balances to available credit (30%)
• Length of credit history (15%)
• Credit mix (10%)
• New credit (10%)

First-time homebuyers who want the best possible deal on a mortgage can make substantial improvements over relatively short periods by tackling the first two — payment history and account balances.

“Pay your bills, and pay them on time,” says Tabitha Mazzara, director of operations at mortgage lender MBANC. “Also, make moves to beautify your debt-to-income ratio by paying down debts.

“Lenders want to loan you money, we really do. That’s our whole job. But we don’t want to take a lot of risks while doing it. If you can prove you’re not a risk and you have a history of paying back money you’ve borrowed, it’s all good.”

If you’re feeling strapped, reinspect your budget. Look for things to cut out while you’re prepping your personal finances for probes by mortgage lenders. Set up automatic payments so that due dates never slip by. Freeze your credit card purchases; pay cash whenever possible. Adopt a pay-down strategy — the snowball or the avalanche — to get your balances into shape.

While you’re at it, do not close accounts that are in good condition. You’ll lose points for credit history, available credit, and credit mix. On the other hand, TheSavvyCouple’s Kline notes, the year before you go house shopping is not the time to go applying for a number of new accounts.

Step Five: Talk to a Nonprofit Credit Counselor

You can do all of the above on your own, of course, if you have the savvy and the discipline. For those who doubt their resolve, or for those who simply need routine coaching up, there are nonprofit credit counseling agencies and housing counselors certified by the federal Department Housing and Urban Development (HUD).

You may consult either without obligation. Your counselor(s) can help you review and understand your credit report, make suggestions about improving your credit score, and even provide guidance about how to prepare for the home-buying experience.

If your finances are a bit rocky, a nonprofit credit counselor may recommend a debt management program, designed to put your monthly payments and balance reductions on autopilot.