Learn how you can understand how credit really works so that you can manage your credit effectively throughout your lifetime…
As TheWealthIncreaser.com stated in the last discussion—credit and how you (and others) could thoroughly understand and benefit from would be discussed in clear and concrete terms.
In the most recent posts you gained a practical understanding of Personal Finance Statements, including a Personal Cash Flow Statement or Budget, an Income Statement, a Balance Sheet and a Net Worth Statement.
In this discussion TheWealthIncreaser.com will “hone in on credit” so that you will have an understanding and practical application of credit that you can use throughout your lifetime as you build wealth–therefore leaving all excuses behind as far as why you can’t achieve credit success!
Even though this discussion may be longer than most that you are accustomed to on TheWealthIncreaser.com–you will have no excuse for not managing your credit effectively throughout your lifetime after reading this blog and applying what you feel is relevant in the management of your finances.
How to Manage Your Debt Before a Major Purchase
A major purchase such as buying a house, car or boat is a big investment–and not only should you be prepared in advance—you should know what to expect throughout the process.
When you manage your credit you are in effect “putting on a show” (pun intended) for lenders of all types who have the power to grant you credit for various purposes. Whether you are seeking approval for your home loan, car loan, boat loan or any other purchase, your lender would be agreeing to lend you all or a portion of the funds needed to cover your purchase.
Because a high-cost purchase often involves the use of borrowing, lenders (as best as they can) want to guarantee that you’re not a “risky borrower” and they want to know that you’ll be able to make your monthly payments on time and in full for the life of the loan.
Lenders will decide whether you’re a risk for a major purchase by looking at how well you’ve managed debt in your past, and how well you’re managing debt at this time. Therefore, having some debt can be a good thing if you have managed your credit well in your past.
This should make sense to you because if you’re making a major purchase where borrowing is involved, you’d expect others who lend you money “would” want to ensure as best they can that they will be paid back according to the terms of the lending agreement.
It is important that you realize that whether you feel that it is fair or not, your payment history shows potential lenders your character and the real likelihood that they would be payed back in the future!
You may want to save as much money as you can before a major purchase—and in some cases that can be a wise strategy.
Even though you may not want your money tied up in debt—borrowing can serve a useful and beneficial purpose if used appropriately and in a wise manner.
You may have a need to borrow if:
- You are hurting for cash to meet a current need and there are no other options
- You anticipate a major purchase and borrowing makes good financial sense
- Over a period of several months your bills are starting to pile up
- You get interest rates that are better than the credit card payments that you are making
- You desire to utilize credit as an overall strategy to build wealth more efficiently (use leverage to your advantage)
Even though you may use borrowing as an overall strategy to reach your goals more efficiently, always realize that “saving money” is always a good idea and cannot be overstated!
However, having some debt before buying your house or any other major purchase could actually be an important factor in getting you approved for your future loan(s)–including an auto loan, boat loan, mortgage loan or rental property acquisitions.
Why having some Debt can be of benefit
To see how well you manage your debt, lenders of all types, including mortgage underwriters will take a detailed look at your credit score, credit history and your debt-to-income ratio (DTI) to see if you are worthy of granting a loan.
In almost all cases where you want credit to work optimally for you, you’ll want to have a high credit score and a low DTI.
A high credit score indicates that you manage your debt reliably and responsibly.
A low DTI indicates that you don’t have too much of your income tied up in paying off debt and make you a less riskier borrower in the eyes of lenders!
Let’s take a closer look at your credit score–and DTI—so that you can achieve more:
Your Credit Score
Virtually every factor in your credit score is defined by your borrowing behavior. If your goal is to create and improve your credit score, you need to take on debt and manage debt as responsibly as you can based on your finances and living circumstances.
Your credit score is usually impacted by the following five factors according to FICO:
(35%)
— Your “payment track record” is the most important factor considered in your credit score. Lenders want to know if you’re a trustworthy borrower, therefore, they want to see if you make on-time payments on your debt.
(30%)
— Owing money on your credit cards, in particular, is not a bad thing. However, if you’re using too much at one time, underwriters might take that to mean that you’re overextending yourself financially–and that is not good.
(15%)
— A longer credit history is favorable to a short credit history. Therefore, if your credit history is limited you won’t necessarily be disqualified from borrowing money–but a longer history is looked at more favorably.
(10%)
— Underwriters want to see how you manage different types of debt or how you manage a mix (credit cards, auto loan, mortgage loan, personal loan, student loan etc,) of credit.
(10%)
— If you’ve opened multiple credit accounts at one time, this is a red flag for underwriters because it can suggest that you’re in financial distress–keep inquiries low if you are in the process of building your credit and you plan to use your credit for a major purchase in the near future (within the next 2 years).
If you were anticipating an auto loan, you want a minimum credit score of 640 and for a mortgage, you’ll typically need a credit score of at least 640 for a conventional loan and possibly 620 for an FHA or other government home loan–depending on the lender.
In many instances it could be best to shoot for a credit score of 700 or more in both instances, as you may be able to save thousands or tens of thousands over the life of the loan(s).
A higher credit score increases your chances of approval, and also increases the loan amount that you’ll be approved for–regardless of the “scoring model” being used.
In particular, a higher credit score could also help you secure a lower mortgage rate, which could save you a significant amount of money over the life of your home loan (in many cases from thousands to possibly tens of thousands)—depending on your mortgage amount and term(s) of the loan.
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Your Debt-to-Income Ratio or (DTI)
Your DTI is a percentage representing how much of your income is put towards paying down debt. Since a mortgage is such a large investment, and your monthly payments could be fairly substantial, underwriters, loan processors, lenders or anyone who plans on lending you money for the purchase will want to make sure that you’ll be able to make those payments on a consistent basis and repay the loan amount and interest.
Therefore it is imperative that you keep your DTI ratio low, the lower—the better—generally speaking!
In general, a DTI of 36% or lower (including housing) is ideal.
Generally, a DTI above 50% for conventional or government loans most likely would not be approved (although there are exceptions). 43% on the back-end and 31% on the front-end is what FHA loan grantors look for, meaning your debt of 31 percent excluding housing (front-end ratio) and your housing and debt income up to 43% (back-end ratio) would be preferable—however some lenders will allow you to exceed those limits–but it may not be wise to do so on your part–particularly if you do not have a properly established emergency fund or have a plan in place to create one.
To calculate your DTI, simply divide your monthly debt (debt that takes 12 months or more to pay off such as your credit cards, auto loan, student loan, personal loan, boat loan etc.) by your monthly gross income.
To calculate your housing plus debt ratio, simply divide your monthly debt (debt that takes 12 months or more to pay off) plus your anticipated housing monthly payment by your monthly gross income.
If your resulting percentage is higher than 50%, you’ll want to work on paying off some of your debt in most cases so that you can get a more favorable loan and also to help improve the odds that you will remain a home owner in the future as life can be unpredictable at times.
Homeowners who purchase with DTI ratios above 50% normally have other “compensating factors” at work such as an expected financial windfall, social security or pension income that will start in one year and other factors that compensates the high ratio–or makes the 50% or more ratio less risky.
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Other Credit & Debt Management Tips
It is important that you reduce your debt to a more favorable level before making a major purchase such as buying a house. It is very important that you maintain a solid credit score by making consistent credit payments, managing your debt at an optimal level and managing your overall finances at a level that is the best that is within you throughout your lifetime.
By maintaining a solid credit score you can get “more favorable loan terms” when you make a major purchase and particularly a mortgage loan–if you desire to become a home owner at this time or in your future.
A solid credit score can also reduce your daily stress levels and your money management will be made more efficient during your lifetime as well!
The following tips can help you manage your debt more efficiently whether you desire to make a major purchase such as buying a house or use credit for other purposes.
Whether you have already purchased your dream home and are currently making monthly mortgage payments or you desire to manage your credit for a home purchase or any other credit goal(s) in your future, you can more effectively and efficiently build your net worth to a more acceptable level by doing the following:
Take a Detailed Look at Your Credit Report
Your credit score is an important qualifying factor for building wealth and qualifying for a mortgage loan at a good or the best rate.
Therefore, it can be a good idea to take a look at your credit report at this time to ensure that everything has been reported correctly and that there aren’t any errors that need correcting.
You wouldn’t want your credit score to be negatively impacted because of mistakes in your credit report–and now you can eliminate that possibility by pulling your credit report at this time and challenging inaccuracies if and when they exist.
You can order your credit report for free from any of the three major credit bureaus: TransUnion, Equifax and Experian, once per year by going to annualcreditreport.com.
Once you have your credit report it is important to look at the following:
- Your personal information
- Your credit accounts
- Your credit inquiries
If you see any errors or inconsistencies anywhere in your credit report, they can be challenged with the credit bureau that created the report and you must exercise your right to do so as soon as you become aware of them.
Consolidate Your Debt if it makes Good Sense to Do So
If you find that you’re making payments on various loans and/or credit accounts, it could possibly save you money (and help you avoid negative stress) to consolidate your debt into one loan.
By doing so you could possibly pay interest on one loan instead of multiple loans!
Therefore, you won’t have multiple payments to keep track of and your stress levels could possibly be reduced. Depending on your debt level and credit position you may be able to use zero percent credit promotions to consolidate a number of credit card payments and pay the debt off faster during the zero percent promo period to avoid high interest charges.
There are caveats that could make this and other approaches unwise—therefore you want to ensure that you have a wholesome approach to managing your finances prior to consolidating your debt and making other financial moves.
Always realize that what may appear prudent on the surface–could work against your best short, intermediate or long-term goals if not analyzed in a careful, critical and accurate manner.
In Many Cases it May Not be Wise to Make Drastic Changes to Your Credit
It can be tempting to pay off debt right before applying for a mortgage–however, doing so could actually hurt your credit score. In many cases when you pay off a debt, your credit score will actually drop temporarily in the short run.
On the flip side, if you’re trying to build credit and try to open multiple credit cards, or take on other debt before applying for a loan, this will also reduce your credit score.
If you are applying for a loan (or anticipate doing so in the near future) a lot of change in your banking activity (large deposits that are not your norm etc.) and taking on new debt before applying for a loan (and particularly a mortgage) is a red flag to lenders and underwriters.
It can indicate that you might not be financially prepared to take on a mortgage!
To put it bluntly, your credit pay off, opening new credit and overall credit and financial behavior must align with your goals!
Create a Budget or Cash Flow Statement as Soon as Possible
Whenever a financial discussion is taking place, budgeting or cash flow management often comes up and many are not enthused by the coversation. Even though you are possibly bored by the conversation, it’s a meaningful way to track your income and expenses and ensure that you’re managing your finances as best you can.
There can possibly be a lot of costs involved with buying a house, and many other major purchases, therefore, you’ll want to make sure that you can afford your monthly payment and meet your other debt obligations in a manner that allows you to enjoy life on a consistent basis.
In most cases, creating a budget or cash flow statement can help you map out your current debt and other expenses in relation to your income so that you can meet your debt obligations from a more advantageous position!
By doing so you can improve your vision and see what’s happening with more clarity and make adjustments as needed.
A personal cash flow statement or budget can give you the peace of mind, confidence and clarity that you need–so that you can truly succeed. You can therefore avoid overspending, and meet all of your other financial responsibilities from a position of strength as opposed to having a cluttered and in many cases overburdened mind that leads to unhealthy stress levels.
Properly Build Your Emergency Fund
Building and properly funding your emergency fund before getting a mortgage may be one of the most important things that you can do to proactively prepare for long-term success.
Even so, it is often overlooked by even those who consider themselves to be savvy money managers!
In life, emergencies of all types will occur and you never know what expenses might arise once you purchase your home or even while you are renting or leasing an apartment or house.
You don’t want all of your money tied up in your mortgage payment (you must manage your DTI effectively) and other monthly payments if, for example, your roof needs to be repaired, car issues occur, your HVAC goes out, plumbing issues occur and you encounter water damage or other concerns.
Many financial professionals suggest that you set aside three to six months worth of expenses in an emergency fund–and that is a wise suggestion in almost all cases.
Conclusion
A major purchase, including buying a house is a big purchase, and it can be daunting to think of getting a mortgage if you are trying to pay down student loans, an auto loan, credit cards, your monthly utility bills and other burdensome debt.
To help you save money and avoid or reduce unhealthy stress, work on paying down your other debt so you can be confident in your ability to make mortgage payments and enjoy your new home–if there is a need for you to do so.
However, you don’t need to be debt-free to buy a house.
In reality, some well-managed debt can boost your credit score, showing mortgage underwriters that you are a responsible borrower and can manage debt effectively!
Your goal is to avoid a financial hole that you’ll never come out of or makes it difficult to manage your finances from month-to-month.
By taking the time to create a budget and analyze your credit report, you can see how you’re doing financially and where some changes (improvements) can or need to be made.
You may be able to consolidate some of your existing debt if it makes good financial sense to do so, or you could completely pay off some of your debt to improve your credit score and financial ratios and make your housing payment more comfortable!
In the end, you just want to make sure that you’re comfortable taking on a mortgage and you can afford to do so in a manner that allows you to enjoy life and live in as stress-free a manner as possible.
You already know how FICO scores are calculated and how you can improve your credit report and credit score.
Additionally you want to be aware of the VantageScore as well, as it is increasing in popularity and has slight differences from the FICO score. VantageScore is the other scoring model that is widely used by some lenders but is not as popular as FICO–but you should be aware of.
However, if you manage your credit well based on the FICO standards—your VantageScore will improve as well!
Just so you are aware of and have a point of comparison the VantageScore consists of:
Payment history (approximately 40%)
The biggest factor in your VantageScore 3.0 credit scores is payment history. VantageScore 3.0 puts more weight than FICO on your payment history–therefore you want to consistently pay your bills on time and avoid being delinquent on your accounts.
A late or missed payment on the VantageScore 3.0 scoring model can significantly harm your credit scores, therefore you must pay all of your creditors in a timely manner.
Your payment history is a record of how often you pay your bills on time and how often you miss your payments or pay late. Therefore, it is imperative that you make your payments on time as that can help improve your payment history and give lenders confidence that you’re likely to make future payments in a timely manner as well.
Age and type of credit (approximately 21%)
VantageScore 3.0 also factors in how long you’ve had different types of credit accounts open.
Ideally, lenders like to see long-term, established lines of credit , therefore having a variety of account types is preferred—as long as you stay up-to-date on your payments. Lenders and underwriters normally like to see that you’ve used a mix of accounts or different types of credit on your credit report to see if you can effectively manage debt.
Your credit history or age of your accounts will indicate the types of credit accounts that you have and will show how long you’ve had them open and active.
By having a longer credit history and showing that you have different types of credit you will improve your score more than if you have a short credit history or just one type of credit on your report, like credit cards or short-term loans.
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Credit utilization (approximately 20%)
The purpose of the credit scoring industry is to help lenders get a clearer picture of the type of borrower you might be if they were to grant you a loan. They want to see how you use credit and using a lower percentage of your available credit at any given time is preferable.
You want to ensure that your credit utilization ratio is below 30% or more preferably below 10%. Another important goal to aim for is to pay your revolving (primarily credit card debt) debt off monthly.
You also want to get into the habit of using all of your credit cards every 4 to 6 months or so to keep the credit cards in your active mix as that will help ensure that your current credit issuers will not close your account due to inactivity.
If you have 6 credit cards use a different one every month for 6 months and then repeat the process–pay them off in full once you get your credit card statement if you are in financial position to do so and you will improve–or at a minimum maintain your credit score and lending power.
In a nutshell, your credit usage compares the amount of credit you’ve utilized to what you can still borrow. You do not want to consistently use all of your available credit, like maxing out lines of credit or carrying high balances on credit cards or loans.
If you carry large balances–particularly on revolving debt, that will hurt your credit score, therefore you must do your best to maintain your balances at less than 30% of your credit limits or preferably 10% to help improve or maintain your credit score.
Balances (approximately 11%)
Be sure to keep the total amount of recently reported balances (current and delinquent) on your credit accounts low as lenders generally like to see low balances as it suggests the chances of you making on-time payments each month is higher.
Paying off your balances monthly is a good way to improve or maintain your credit and is something that you should strive to do–if you are not doing so at this time as you must avoid delinquent payments as best you can.
Your total balance includes all of your credit balances, and by maintaining low balances (primarily and particularly on your revolving debt) and making your required payments on time you can help improve your score and give lenders more confidence that you’re financially responsible.
Recent credit (approximately 5%)
If you applied for a new credit card lately or you have taken out a personal loan–lenders will want to know. Your recent credit activity, including recently opened credit accounts and credit inquiries, can be an indicator of your future financial behavior.
Your recent credit activity typically covers credit checks made over the past two years. It factors in any new credit cards or loans that you’ve applied for or opened. A large number of recent credit checks, also known as credit inquiries by lenders could indicate that you’re in financial distress or opening credit lines in an irresponsible manner.
On the other hand, few, if any inquiries in your credit history may help your score.
Available credit (approximately 3%)
Although not a huge factor, lenders typically like to see that you’re only taking out the credit that you need. By having available credit that you don’t use you are showing lenders that you are not over-extending yourself.
Therefore, you want to keep a good amount (70% or more of your available credit) of credit available that you don’t use.
Your available credit has the least impact on your credit score in the Vantage 3.0 scoring model. This factor takes into account the amount of credit you can access and use. Therefore, maintaining a low balance at or below 30% of your available credit could help improve your credit score.
Although you generally can’t control how your score is calculated, you can protect your credit score by paying your bills on time, maintaining a good mix of credit, avoiding high balances, and using only a fraction of your total available credit.
Key Points
- Your credit score is a number, typically between 300 and 850, that shows potential lenders a snapshot of your credit history. Whether your score falls into an “excellent” range, “poor” range, or “somewhere” in the middle, it may impact your ability to access loans and services at a good or the best rate.
- Many credit scoring providers use the VantageScore 3.0 scoring model which calculates your score based on six factors. Each factor has a different impact on your credit score. However, the majority of lenders use the FICO 8 scoring model which calculates your score based on five factors. Factors and the applicable percentages on both scoring models are based on your unique credit file, so “percentages that are applicable to you” may vary according to your unique credit file.
- Paying your bills on time, using only the credit you need, and maintaining different types of credit may have a positive impact on your credit score–regardless of the scoring model. Also keep in mind that there are other scoring model versions for specific industries and other scoring models (including FICO and VantageScore) are updated to new versions and many lenders will use older versions, newer versions, industry specific versions and the like.
- A good credit score might make a difference in whether you get favorable rates when applying for credit whether a major purchase such as a car or home, a credit card, employment, insurance, rental property and other areas of commerce (the 4th bureau–cell phones, utilities etc.).
- Your goal should be to gain a general understanding of credit and not have a cluttered mind about credit and your finances, including what has been discussed above in this article. Even so, you always need to know that Negative information, credit Utilization, the Time length of your accounts, the Type of accounts that you have and the number of Inquiries in your credit file are very important to understand and apply to your unique credit position. Your understanding of a “budget or cash flow statement” and “properly establishing an emergency fund” are also a key takeaways from this discussion on credit.
To further drive home credit scores you must understand that FICO ranges from 300 to 850 while VantageScore also ranges from 300 to 850 but have slightly different weighting factors and weights as mentioned above!
- Knowing where your credit score falls within the FICO and VantageScore ranges can help you get a sense of whether you might qualify for a loan or credit card—and what kind of rate you might be offered.
- There are a few key differences between the VantageScore and FICO scoring models, including how they weigh different factors in determining your scores. They both have a score range of 300 to 850, but there primary difference is the way the ranges are considered–poor, fair, good or excellent.
| Vantagescore 3.0
|
FICO | |
| Excellent | 781–850 | 800–850 |
| Very good | N/A | 740–799 |
| Good | 661–780 | 670–739 |
| Fair | 601–660 | 580–669 |
| Poor | 500–600 | < 580 |
| Very poor | < 500 | — |
Why does a good credit score matter?
- A good credit score varies across credit scoring models, however a score of 680 or higher is generally considered a good score with virtually all scoring models.
- For FICO, a good score ranges from 670 to 739. VantageScore considers a score of 661 to 780 to be good.
- A credit score that falls in the good (680 and above) to excellent (800 and above) range should always be your goal. Lenders will look at a variety of factors when considering a loan or credit application and higher credit scores play a huge role in getting approved at a good or the best rate.
- You want to get the lowest interest rate possible and the most competitive terms possible, therefore an excellent credit score allows you to have an even better chance of being offered the best rates and terms available.
If you have poor or bad credit scores, you may be able to get approved by some lenders, but be prepared to pay higher rates than if you had good to excellent credit.
You may also be required to make a down payment (or larger down-payment) on a loan or get a cosigner. Consider improving your credit position and pursuing your loan options at a later time if at all possible if your credit position is not ideal at this time.
The Consumer Financial Protection Bureau recommends keeping your credit utilization ratio below 30%. This may not always be possible based on your overall credit profile and your short, intermediate and long-term goals, but it’s a good benchmark to keep in mind.
Aim for under 10% if possible!
Also realize that there are many credit resources available that can help you manage your credit and credit score more effectively and it is “your responsibility” to know what is available and can possibly benefit you and your family.
Micro lending companies, investment companies, banks, credit card issuers and many others now offer credit products and services that can assist you as you manage your credit and finances at a nominal or free level–and may be appropriate for you depending on your financial position and future goals.
Many different credit scoring models are available and it is important that you know what model is in use or what model your potential credit grantor will use when you apply for a loan!
Credit Score FAQ
How long will it take me to improve my credit to an acceptable level?
- Your current credit position is unique and the time needed will vary from person to person and the type of loan that you will be pursuing along with your credit behavior over the past few years.
If you anticipate a major purchase such as a home purchase it may take anywhere from 1 month to 2 years to get your credit file in position to get a loan at a good rate. However your credit patterns over the past few years will determine the real time frame.
By addressing your credit concerns at this time you are getting out front of your credit and your utilization of credit in the future will be more advantageous for you and your family.
Does checking my credit scores affect my credit?
- Checking your credit scores and reports yourself won’t hurt your credit—it’s considered a soft inquiry. By keeping tabs on your credit scores you can spot potential issues early. If your scores suddenly drop, it could be a sign that there’s an error in your credit report information, new credit was opened or that you may be a victim of identity theft. In addition to your credit scores, you also want to check your credit file at the credit bureaus on a planned basis as well. Also, credit checks by your current creditors are also considered soft inquiries.
What is the maximum credit score that I should aim for?
- Getting an 850 credit score is possible, but uncommon and unrealistic in most cases. Only about 1% of all FICO scores in the United States are 850, according to most public data. Those with credit scores of 850 generally have a low credit utilization rate, no late payments on their credit reports and a longer credit history than most.
- Keep in mind that having a “perfect” credit scores of 850 shouldn’t really be your goal. You can still qualify for the best loan rates and terms if your credit scores are considered excellent (roughly 800 or higher)–therefore aim for a score of 800 or more and then maintain that score and you will put yourself among the best potential lending candidates in the eyes of most–if not all–lenders.
What credit scores do I need to get approved for a credit card?
- There’s no agreed upon minimum credit score needed to get approved for a credit card and issuer’s have their own criteria. Credit card issuers have different score requirements for their credit cards, and they often consider factors beyond your credit scores when deciding to approve you for a card.
- In general, if you have higher scores, you’re more likely to qualify for most credit cards–and at a good or best interest rates. If your credit is fair or poor, your options will be more limited and you may receive a lower credit limit and higher interest rate or you may have to start with a secured credit card. If you are new to credit, you can establish a credit file within 6 months.
Which credit score is more important?
- No one credit score holds more weight than the others generally speaking. Different lenders use different credit scores and versions. Regardless of the scoring model or score that is used, making on-time payments, minimizing debt utilization, paying on time over time, maintaining different types of credit (cards and loans) and limiting new credit applications or inquiries, can help keep your credit in good to excellent shape and you will be looked at favorably by most lenders.
By stretching your mind and learning more about credit and wealth building, you are now on a serious path toward reaching your goals and ensuring a more prosperous future for yourself and your loved ones.
All the best as you are no longer “frightened” as you pursue a lifetime of credit and financial success…
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