Establish Credit To Buy A Home
Last weekend I visited with a young couple who was looking to be preapproved for an FHA loan so that they could buy a home. Their excitement was apparent as we went through the application and discussed the different first-time homebuyer benefits and options that are currently available. Unfortunately, the excitement soon dissipated when I pulled their credit report. The couple thought that they had been able to build good credit history, but they were wrong. The husband’s credit scores were below 500 and the wife had no credit scores at all. The only items on their credit report were two recently opened credit cards that were maxed out and a couple of collection accounts. The couple was disappointed to learn that they could not qualify for a mortgage at the current time and fearful that they would never be able to establish good credit. Fortunately, we were able to design a plan to help them build their credit history and increase their credit scores. I explained to them that, despite this setback, they are still only months – not years – away from home ownership. It is critical that anybody who has a desire to buy a home knows how to establish a strong credit history. Doing so properly will reduce your expenses and increase your buying power and earning capacity throughout your life. So how is it done?
The following are some key steps to establishing excellent credit history and starting the path to home ownership.
Know What You Are Trying to Accomplish
If you fail to plan, you plan to fail. For that reason, the first step is to know what a credit report is and how it is derived. By understanding what the goal is, you can work to obtain it. Some experts have advised that the ideal credit report will have a mortgage, an installment loan (such as an auto loan), and two to five credit cards (at least one from one of the major providers such as VISA or MasterCard) with low balances. A credit profile such as this, if well maintained, will certainly result in a high credit score with time. My experience has proven that a person should aspire to have a credit score over 720 because many of the mortgage banks reserve the lowest interest rates for borrowers in this category. Once you understand what a credit report is and you have set a goal as to how to achieve it, start to execute your plan.
Know The Common Credit Qualifying Criteria
What factors are a lender going to look at when deciding to issue you credit? On almost all loan applications – whether for a credit card or mortgage – banks want to see that you have the capacity to repay the debt. So, if you don’t have credit history, a lender will look at your assets, stability, and income (or earning potential).
Assets. It is very important that you open and maintain bank accounts. By doing so, you have documentation of your ability to budget and save, thus demonstrating financial responsibility. I recommend that when you are starting out and choosing a banking relationship that you look for a local community bank or credit union. Many times, smaller, customer-centric, institutions know you individually and not as just an account number. Because of that, they may have lower banking fees and more flexible lending criteria. You may have an opportunity to sit down face-to-face with your banker who will look at your total financial scenario and potential vs. having to apply by phone or internet to a faceless automated system that approve you only on your credit score. Many local community banks and credit unions have lending programs designed specifically for people who are looking to establish their credit history because they want to gain your long-term business. Just make sure that they actually report your loan information to the credit bureaus.
Stability. Many lenders want to see how long you have been at your current address and how often you move. Frequently moving isn’t necessarily a reason to be declined (unless you are breaking leases and defaulting on contractual obligations), but stability does go a long way to compensate for a lack of credit history. One of the key factors of stability is establishing sources of “alternative credit”. For that reason, it is important that you try to create a history of documented bills in your name such as rent, utilities, auto insurance, phone or cell phone, etc (paying a friend or family member probably won’t do the job). Although they typically do not show up on your credit report, they can be used by a lender to issue credit. In fact, FHA guidelines will allow you to qualify for a mortgage even if you have no credit history and FICO scores if you can document three “alternative credit” sources with at least a twelve month history of on-time payments.
Income (or Earning Potential). Your income will be a key factor in establishing credit. Lenders want to see that you have stable employment and sufficient income to repay the debt on top of your standard living expenses. If you are a college student and you are not working, take advantage of the opportunity to apply for “student credit card” offers. Lenders are willing to approve you based on your future earning potential and they are looking to capture your long-term business. However, please understand that obtaining credit card debt that you max out or can not maintain is very bad and can seriously derail your opportunities to establish high caliber credit history.
How Do You Actually Get The First Accounts On Your Credit History
Utilize Someone Else’s Credit. The easiest way to start building your credit history is to utilize someone else’s credit that is already established. If you know someone, such as a family member, that you trust (and they trust you), you can be added onto an existing credit card as a joint account holder. This will include the credit card history into your credit report. Obviously, there is risk in doing this. If the person has previous late payments or suffers from more late payments, this information will go on your credit also. The same applies to maxed out credit limits. So, it could be a good and a bad thing; and therefore, you need to choose wisely.
Another way that you can utilize someone else’s credit is to have a co-signer. Many times a bank will be willing to loan you money if you have a co-signer who has established credit history and can demonstrate financial stability. The problem with this is that if YOU don’t make the payments, you are putting their credit at risk. I currently have a client who is looking to buy a house but can’t until we repair his credit report. A few years ago, his friend asked him to co-sign on an auto loan and then his friend let the car be repossessed. Now my client has a repossession showing on his credit report.
This is how I was able to start building my credit. The first loan I ever got was with my local credit union and my brother co-signed on a used car loan for me. The credit union had a program that allowed me to refinance the car into my name only (removing my brother from liability) once I had made six on-time payments.
Department Store and Gas Cards. So, what do you do if you aren’t in college and you don’t have a reliable person that is close enough to you to add you as a joint account holder or to act as a co-signer? Try applying for a department store card or a gas card. It is much easier to get a department store card than it is to get a card from a major provider such as Visa or MasterCard. However, I recommend that you keep a minimum balance (not a 0 balance, you need to create payment history) on these types of cards because their interest rates are very high. Don’t be surprised if they reach up to 21% to 33%. It is also fairly easy to get a gas card, such as Texaco, ExxonMobil, etc. Just make sure that they report your payment history to any of the major credit bureaus. If not, then it isn’t serving its purpose and you will just be paying high interest.
Be prudent and stick to a credit building plan. Just because a company will approve you doesn’t mean that you should approve them. You don’t need to have a large number of credit card accounts. In fact, it could actually hurt you to have too many. Too many inquiries and too many new accounts in a short period of time can drop your credit score. Don’t use over 30% of your credit limit on any one card if you want the best credit-building results and never miss payments.
Secured Credit Cards. Another way to start building your credit history is by obtaining a secured credit card. A secured credit card is a type of credit card secured by a deposit account that you place with the card issuer. Don’t assume that your payments can be taken out of your deposit. You are still expected to make regular payments, as with a regular credit card, but should you default on a payment, the card issuer has the option of recovering losses out of the deposit.
The advantage of the secured card when you are trying to establish your credit history is that many offer approval with no credit check and most companies report regularly to the major credit bureaus. This allows for building of positive credit history. With that being said, it is critical that you ensure that the issuer of the secured credit card that you select reports to the major credit bureaus.
Fees and service charges for secured credit cards often exceed those charged for ordinary non-secured credit cards. Even knowing this, you must use caution when choosing your credit card issuer because many charge egregiously high application fees and annual fees. Further, if you make your payment after the payment grace period, they may charge extremely high penalizing interest rates. So, do your homework in advance. As I recommended before, start with your local community bank or credit union.
You can also check out “the credit card search engine“.
Move Forward
Remember, now that you know how to be approved for credit, you must build credit with a plan. It is crucial that you do not make avoidable mistakes as this will affect your buying power for years to come.
Here are a few last points of advice.
- Again, build with a plan. I recommend that if you are starting from scratch, your goal is to try to open three credit accounts and achieve 12 months of payment history (without late payments of course) in an 18 month period.
- Don’t make to many inquiries and applications.
- Don’t use more than 30% of your limit on any one credit card.
- Don’t pay off your credit cards. You should maintain a small monthly balance. This may not be the most prudent financial advice, but good advice for establishing your credit history.
- Try to establish a mix of installment and revolving credit.
- Don’t pay late.
Good luck. Soon you will have the necessary credit history to buy your first home and FHA mortgage loans are great for first-time homebuyers.
If you have any questions regarding establishing credit history how it impacts on your ability to obtain an FHA mortgage for your next home loan, please contact me today.
