To buy a house, your credit standing is key. Your lender will review your credit when you apply for a mortgage – and what they find will determine if you are approved and the interest rate you’ll be charged. Reviewing your own credit history and standing will help you know how lenders might evaluate you and whether you need to take action to improve your credit.
What is credit?
Credit lets you obtain something now for no money (or less than the full cost of the item) out of pocket, and pay for it over a specific period of time.
There are two types of credit:
- Open-end credit is extended on an ongoing basis, but usually with a limit on how much you may borrow. Yes, we’re talking about credit cards, such as VISA® and MasterCard®. It’s also known as “revolving credit” because as you repay the balance due, credit up to a specified limit is then available for your use again.
- Closed-end credit is extended on a one-time, limited basis, such as a car or personal loan. Although you may still have a positive relationship with the lender after paying off the obligation, you’ll still need to requalify each and every time you want another loan.
Those who extend credit are called creditors – most commonly, department stores, finance companies, oil companies, credit unions, commercial banks and credit card companies. Creditors look at 2 things when deciding whether to extend credit:
- You as a credit risk. Each creditor has different ways of evaluating applications for credit. Most review various factors in order to evaluate the likelihood you’ll repay the amount borrowed over a certain period of time. Those factors include:
- Length of employment
- How long you've lived at one residence
- Previous credit history
- Amount of outstanding debts
- Stability of your checking and savings accounts
- Number of dependents
- The collateral you are purchasing. Basically, the bigger the purchase, the greater the scrutiny on your credit history and your ability to repay. If you fail to make payments on what you buy with credit, it's easier for a creditor to repossess items like furniture and appliances than to foreclose on a home. Creditors may still extend credit to people with a questionable ability to pay when it comes to purchases like refrigerators and entertainment systems.
But when a home has been posted as collateral for a loan, the foreclosure process can be costly and time-consuming. The lender assumes a greater amount of risk at a lower interest rate. Therefore, the lender is going to evaluate you and your credit history more carefully when you're trying to buy a house. Unfortunately, this is where some people learn their first real credit lesson — when credit is really important — because they are shocked to find they have been denied based on their credit history.
Establishing a good credit history
Establishing a good credit history is actually pretty simple:
- Open a checking and savings account. Maintain your checking account by keeping enough money in it to cover all regular expenses. Make regular deposits in your savings account to establish a history of savings.
- Apply for credit gradually. Once your checking and savings accounts are in good working order, apply for credit through a major bank or retail stores. Use retail store credit cards wisely – they are easier to acquire with low or no credit than a credit card from a bank, but they often come with higher rates and fees.
- Don't apply for more credit than you can manage. A credit card establishes you with credit as soon as your application has been approved. You might want to start by using credit just for regular monthly expenses like your cell phone and energy bills. You’ll know how much you need each month to pay off your credit card in full, and you’ll build credit history just by covering your regular expenses.
- Make regular payments for the products or services you purchase with credit. Every time you make a payment, you are building a favorable credit history.
Protecting your good credit standing
Failure to repay credit extended as agreed is where most people get in trouble.
- Late payments affect your credit history. It doesn't matter that the credit card balance is only $5, or that the payment is only one day late, or that you pay the late fee. Failure to pay on time will put a black mark on your credit history that can last for a year or more.
- Minimum payments are another trouble spot. Making the minimum payment is just that – the bare minimum. It does very little to reduce your outstanding debt. Meanwhile, interest and annual fees can significantly add up over time. It’s ideal to pay your credit card balance in full every month.
- Use credit effectively. Determine how much credit you can comfortably afford. Develop a household budget — a detailed list of your income and expenses. This will help you know how much you can comfortably purchase on credit and still pay off the balance at the end of the month. Evaluate larger purchases (those outside your normal household budget) based on need, and create a payment schedule to make sure that the debt is paid off quickly.
- Ask for help. If you experience unexpected financial difficulty and start to fall behind on payments, contact your creditors right away – they may be willing to work with you on a reduced payment plan that helps you get back on your feet and does the least amount of damage to your credit history.
It may take some time, but bad credit can be fixed. Once you start making regular, on-time payments and build that positive history, your credit standing will improve and look more attractive to future creditors.
You may want to contact a professional financial counselor or a credit- and budget-counseling agency, if you need help developing a budget/debt reduction plan.