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What You Need to Know About Credit Scores and Home Buying

When it comes to home buying, one of the most critical factors you should consider before signing on the dotted line is your credit score. Your credit score serves as an indicator of your financial responsibility, and it's most commonly reported by the three major credit bureaus, namely TransUnion, Equifax, and Experian.

What’s your credit score? If you aren't sure, don't worry, you're not alone. Many Americans don't understand the importance of their credit scores and how closely they relate to your home financing. Here are some helpful hints about credit scores and home buying that you might find beneficial as you partake in the journey of financing your first home purchase.

Credit Score and FICO

Your credit score is a substantial number that helps determine whether you're approved for loans, insurance, or credit cards. Credit scores are calculated according to the information in your credit report, which lists your payment history and outstanding debt. While several different credit scoring models exist, most lenders use FICO scores when deciding whether to approve a loan application or issue an insurance policy. The higher your score, generally speaking, the better chance you have of getting approved for a home loan.

FICO, which stands for Fair Isaac Corporation, is a company that determines credit scores. They do so using a FICO scoring system, which its founder Bill Fair originally developed. (All three major credit reporting bureaus now use it.) The scores range from 300-850, with higher numbers indicating better creditworthiness.

A good FICO score is necessary for obtaining home loans and other loan products. Five different factors determine your FICO score: 35% Payment history, 30% Amounts owed, 15% Length of credit history, 10% New credit accounts opened, 10% Types of credit used. So let's take a quick look at these five determining factors:

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1.  Payment History (35%)

This is your track record of making on-time payments. The longer you make payments on time, with few exceptions, such as a short stint in bankruptcy, liens, the collection items, or temporary foreclosure, the higher your score will be. Late or missed payments can damage your credit score. Your payment history makes the most extensive part (35%0 of your FICO score.

2.  Amounts Owed (30%)

Most people may not know how much information from your debt life goes into calculating your FICO Score. This measures how much you owe versus how much available credit you have. According to FICO, 30% of your score is determined by the amount owed on revolving credit cards, retail accounts installment loans, and other consumer loans. These debts can include mortgages, car loans, student loans, or department store cards. Paying on time is critical in determining a good FICO Score.

3.  Length of Credit History (15)

For your FICO score, FICO considers various factors from credit history. One of these is the length of credit history, which accounts for 15% of your total score. Your credit history shows how you've managed credit over time, and that's important information when it comes to risk evaluation. The longer you have established credit lines open, such as installment loans or credit cards, will help increase your score—as well as a mix of old and new accounts.

4.  New Credit Accounts Opened (10%)

The newness of your credit accounts can be a detriment to your score. New credit accounts will affect 10% of your FICO score, including store credit cards. If you open more than two new accounts in a short period, it can raise red flags. The result: Your risk is judged to be higher than before.

5.  Types of Credit Used (10%)

A total of 10% of your FICO score is based on what type of credits you're using. If you have several active accounts or too much of your available credit is in use, it's likely to affect your FICO score. FICO says credit mix isn't a determining factor, but it can be crucial if you don't have much in your credit history.

Bankruptcy and Foreclosure

A bankruptcy, foreclosure, short sale, or any other event that negatively impacts your credit score can negatively impact your eligibility for a VA loan and other conventional loans.

Most lenders will perform a credit check, meaning an in-depth evaluation of your credit history, to determine your level of risk. If you've declared bankruptcy or been through foreclosure, your score may reflect that negative information for up to 7 years.

While some lenders are willing to overlook previous financial problems, others will consider bankruptcy risky and deny loans altogether. Check with several lenders before applying for financing if bankruptcy or foreclosure is on your credit report. Your best bet is finding a lender who has experience working with homeowners who have had these issues before.

Bottom Line

Most people aren't familiar with how credit scores work, especially when buying a home. A good credit score can enormously impact your ability to qualify for a mortgage loan, so you must understand all aspects of your credit history and FICO score. The rest of your homeownership life may depend on it.

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