Credit Information and the Homebuying Process

For many homebuyers, credit is a big consideration in the buying process. In applying for a mortgage, your credit may be the single factor that opens or closes the door to purchasing the home you want at a low interest rate. You may believe you have a strong credit rating but have never actually seen your credit report. Or perhaps you're concerned that past credit problems will come back to haunt you as you apply for a mortgage

Whichever boat you're in, the first step is the same: Obtain a copy of your credit report for a small fee and review it for accuracy. Credit reports are maintained by three credit reporting agencies: Experian, TransUnion and Equifax. It's a good idea to obtain your credit report from all three agencies, since each may contain different information and you don't know which agency will be supplying your report to your lender.

If there is incorrect or missing information that would improve your credit score, report it to the credit bureau. Under the Fair Credit Reporting Act, consumers have the right to review and contest information in their credit reports. Even if your credit report reads exactly like you expected and your credit is in fine shape, going into the mortgage application procedure with peace of mind is worth the nominal fee.

What is credit?

Credit is a record of a person's debts and payment history. Credit bureaus compile individual reports of consumer debt through an array of sources, including credit card companies, banks, the IRS, department stores and gasoline companies, and any other entities granting loans. A credit report is a résumé of your financial performance, with information on your payment standing for all the accounts you've held for the past seven to 10 years (seven years for accounts not paid as agreed and 10 years for accounts paid as agreed).

What is a credit score?

Credit scores, also called "beacon scores," are composites that indicate how likely you are to pay on a loan or credit card as agreed based upon your payment history, amount of debts, length of credit history and types of credit in use. The credit grantor reviewing your loan application compiles your score based on information from your credit report and other data, including your income level.

Fair, Isaac and Company (FICO) developed the mathematical formula for establishing scores. Scores range from 300 (poor) to 850 (excellent), and the rule of thumb is the higher the score, the lower the risk to lenders.

In the past, consumers have not been allowed to view their credit score or be informed of the factors that determined their scores. However, C.A.R.-sponsored SB 1607, signed by California Gov. Gray Davis on Oct. 2, 2000, granted California homebuyers access to their credit scores and pertinent information about what factors determined their scores. The legislation, which becomes effective July 1, 2001, also allows consumers to receive their credit scores when they request copies of their credit files for a nominal fee.

What role does credit play?

Lenders review credit reports to determine debts owed and if they are repaid according to the terms of the initial contract. If you have any outstanding debt, lenders will analyze your debt-to-income ratio and how that debt will factor into your ability to make your mortgage payments.

What do I do when I get my report?

Read through it carefully, paying extra attention to the section on your account payment history.

How do I establish credit?

If you have never taken out a credit card or borrowed money from a financial institution, or if your accounts are young, you can establish credit history by having your rent payments to landlords and monthly payments to utility companies added to your credit report.

How do I re-establish good credit?

If your credit report contains negative information, such as frequent late payments, repossessions, collection activity or bankruptcy, you may want to wait to apply until after you've improved your credit record. Rebuild your credit by showing strong payment history in the years following any problems. Most lenders prefer for three years to have passed since a foreclosure on a mortgage and at least two years since bankruptcy. Lenders are willing to forgive past black marks on a credit report if you establish a pattern of responsible debt repayment.

How do I correct a mistake?

Follow the directions of the credit bureau issuing your report. The bureau will contact the source of the information in question and attempt to resolve the dispute. Also, if late payment information is accurate but you have a good explanation (e.g., you were laid off from work or became very ill), you are allowed to add that information to your report.

Be Wise to These 5 Big Credit Myths

Those “a-ha!” moments. Key takeaways. Life lessons. Whatever you may call them, everyone has them at some point, where we look back and say, “I wish I would have known that sooner! Why didn’t someone tell me?” It often seems like credit and finances are a part of life where realizations come about that way. And there’s no bigger time to think about your credit than when you’re buying a house.

Each person’s financial journey is different—but there are ways to be smart about credit that can be useful to people at many different points in their life. Here are just a few of the most widespread credit myths that persist; knowing the truth about these can help you evaluate your options and stay energized about your finances.

1. Myth: There’s only one credit score

Your credit score is a measure that lenders use to determine your creditworthiness on a scale from low to high. These scores differ in small but important ways according to which credit scoring model is used, and the factors that it considers from within your credit information. Seeing how your scores differ can be an effective way to capture a better sense of your total credit picture at a given time, like when you’re considering a major purchase such as a home.

2. Myth: Checking your credit report can hurt your score

One of the most common misconceptions about your credit score is that by requesting a copy of it, you’ll damage it. When you apply for a new line of credit and a lender looks at your credit report, an inquiry known as a hard inquiry will appear. Having too many of these on your report may indicate that you’re seeking credit from many places and trying to overspend: not a good sign.

But, if you’re looking at your own credit report, the inquiry is known as a soft inquiry, and these have no impact on your credit score. Be confident that examining your own information is a good thing, and your score won’t suffer from your interest in it.

3. Myth: There’s nothing you can do about something bad on your credit report

Your credit report is an accumulation of information about how you use credit. A common misconception is that information on your credit report is permanent—but that’s not true. Items that cause concern, like late payments or accounts in collections, eventually come off your report. Your credit report doesn’t show each transaction since you opened your first credit account (unless that happened in the recent past). Most credit scoring formulas show the most recent, and most relevant information in your report.

If there are things on your report that you don’t recognize, it may be evidence of fraudulent activity. If that’s the case, each credit bureau has a process for reporting the suspicious activity. Checking your report regularly can help you stay on top of any fraudulent activity that criminals may attempt.

4. Myth: You can avoid credit problems by only using cash

Cash is great for many of life’s smaller purchases, but for life’s larger expenses – like a home – you likely won’t be able to pay in cash. Those are the times you’ll need to use credit. To get the best rates from your lender, your credit score will have to be in good shape. Don’t run from your credit problems by trying to avoid using credit altogether. Keeping your credit utilization low and making sure to use credit wisely can show that you’re responsible with your finances. Then, when you’re ready to make a big purchase, your credit score can support your creditworthiness to potential lenders.

5. Myth: If you have bad credit, you will never be approved for a loan

If your credit isn’t at its best, that doesn’t mean that you can’t be approved for a loan you may need now. It could mean that you likely won’t be eligible for the best rates that the lender can offer, however. Having to pay back more in interest on a loan you’re seeking now may be the reminder you need to keep better tabs on your credit score. It’s never too late to start learning about how to take care of your credit for the future. In the long run, it may be able to save you money—your future self will thank you!

How to improve your credit score

These fixes will help you get better rates

A credit score tells lenders whether you're a safe bet when it comes to trusting you with credit. The number is an indicator of whether you pay bills on time and whether you have outstanding debt, so it helps lenders determine whether you qualify for a mortgage, credit card or loan, and for how much. We'll show you how to obtain your score and improve it so that you can get the best possible rates.

How your credit score is calculated

You actually have three credit scores, one for each of the three credit bureaus: Equifax, Experian and TransUnion. Each score is based on that particular bureau's information about your financial history, and as that info changes, so does your score.

Credit scores are also called FICO scores, because the scores are usually generated by software developed by Fair Isaac and Company. FICO scores have different names at each of the three credit bureaus, but they're developed using the same method.

Credit scores are calculated with information from five categories:

• Payment history (35 percent). If you've paid bills late, had an account in collection or declared bankruptcy, your credit score has taken a serious hit. Recent problems have greater impact than older ones.
• Amounts owed (30 percent). This area accounts for how much debt you have, what kinds and how close you are to your credit limit.
• Length of credit history (15 percent). Older accounts improve your score, because they indicate that you've been able to maintain good standing.
• New credit (10 percent). Opening a number of new accounts in a short time frame may decrease your score.
• Types of credit used (10 percent). Having a few different types of accounts (credit cards, retail accounts, installment loans, mortgages) has a positive affect on your score.

What's a good score, anyway?

Credit scores range from 300 to 850, and any score above 720 is considered a good score. If you have a score of 740 or higher, you will qualify for the best rates. On the other hand, if your score is 619 or lower, you will have a difficult time getting a loan or credit card, and if your score is below 559, it is unlikely that you will qualify for a loan.

Scores can vary from agency to agency, based on whether the information they have collected about you is complete and accurate. If there are varying scores, a lender will usually go by the middle score.

How do I find out what my credit score is?

Once every 12 months, you are eligible for a free copy of your credit report from each of the three national consumer reporting agencies. These reports show whether you pay your bills on time, have filed for bankruptcy and even whether you have been sued or arrested.

While you're entitled to free credit reports, you'll have to pay to find out your credit score. You can order your score from each of the three reporting agencies' websites.

To bump up your FICO score, try these tips:

• Dispute incorrect information in your credit report. If you find errors, complete the dispute form included with your report or write a letter to the reporting agency. In your report, identify the mistakes and clearly state why they are incorrect. Send photocopies of your report with the mistakes circled, and include copies of documents that support your argument.
• Pay your bills on time. Delinquent payments make a big dent in your score, so do whatever it takes to make sure that you pay your bills on time. Set up automatic debits and payment reminders so that you don't miss another due date.
• Minimize your debt. Pay off your debt as quickly as you can. Keep balances on credit cards as low as possible and pay off the debt, rather than transferring balances from card to card.
• Settle any debt in collections. Contact the collectors to negotiate a pay-off settlement. Make sure you receive the collector's agreement in writing before you send in any payment.
• Recognize that negative information will stay on your report for a while. Most negative information, if it is accurate, stays on your report for seven years. The exception to this rule is bankruptcy, which remains for 10 years.

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The Top 5 Ways to Boost your Credit Score

Don't let your less-than-stellar credit score get you down. Instead, check out these 5 crucial steps to raise your score:

1. Monitor your credit. You can't boost your credit score if you don't even know what it is, much less why. In order to make improvements, you need to know your credit scores and learn more about your credit history and the accounts that affect it. The top credit monitoring services not only provide you with your 3-bureau credit report and scores for free, but they also monitor your credit daily and alert you of any changes. This will help you get educated about your credit and protect you from identity fraud, which can be detrimental to your score. On top of providing you with your personal credit information, many of these services, like Identity Guard, for example, offer personalized "what-if simulators" that will estimate how your credit scores might improve if you took various actions. Not only that, but they explain how certain items in your credit history have positively or negatively affected your score.
Services we recommend include Identity Guard, which monitors your credit daily, updates your credit score every 3 months and comes with a complimentary subscription to Zone Alarm Internet Security Suite, and FreeScoresAndMore.com, which includes all of the same perks plus updates your report and scores every month. Read full reviews of our top picks for credit report monitoring here.
Want to give it a try? Get your 3-bureau credit scores for free by signing up for a free trial.

2. Fix any errors on your credit report. Once you start looking at your credit reports, there is a possibility that you may find an error. In fact, almost 52 million Americans had errors on their credit reports in 2012, according to the FTC. These errors may be simple office mistakes or worse, identity fraud. No matter what the cause of the error is, it could be lowering your credit score. Credit monitoring services like Identity Guard, FreeScoresAndMore.com and TrustedID have helpful resources that can help you file disputes to the credit bureaus, plus they have knowledgable customer support that can help you to boot.
In order to fix any credit report errors, you need to contact the particular credit bureau in which the error was found. To do this, you must first review all three of your credit reports — Equifax, Experian and Transunion. As discussed above, the easiest way to get your credit reports is to sign up for credit monitoring.
If you only wish to look at your credit report to find any errors, you should note that every consumer is entitled to a free credit report each year from annualcreditreport.com. The reason why we recommend signing up for an ongoing credit report monitoring service, however, is because annualcreditreport.com does not provide you with credit scores, it does not help explain your credit scores and because you can only get the report once a year, you will not get the benefit of monitoring, which will help alert you to any changes and in turn, any errors.

3. Minimize your Credit Utilization Ratio. In order to fix your credit score, it is important to know specific variables that affect it. On top of fixing credit report errors and making timely payments on your loans (which I will discuss below), considering your Credit Utilization Ratio is a key element in boosting  your score. The ratio is calculated like this:

A higher credit utilization ratio affects your credit score negatively because it shows that you are using more of your credit limit. In other words, it is good to have a large amount of credit available, but bad to be using a large fraction of it.
To combat a high credit utilization ratio:
- Try not using your loans and/or credit cards to their limit.
- Do not close old credit cards, even if you do not use them. The more credit you have available and not in use, the lower (better) your credit utilization ratio will be
- If you do not have enough available credit to lower your ratio, open a new credit card. Currently, there are a number of cards that offer 0% interest for the first 12 to 18 months, read up on these credit cards here.
Note that if you're thinking of signing up for a new credit card, make sure to only apply if you think you will be approved. This is because the credit inquiries that result  from applying for a credit card may lower your credit score slightly in the short term; however, if you are approved, the improvement in your credit utilization ratio will more than make up for the initial effect of applying for credit. Want to learn more about signing up? Visit our credit card FAQs page.

4. Stay on top of your balances and payments.

If you want to stay on top of your credit score, you need to stay on top of your credit accounts. Not making payments on time lowers your credit score significantly and causes you to pay finance charges. Sign onto your accounts online and make sure you know your balances and payment deadlines, in short — get organized. If you are currently in default on a credit account, it is definitely best to at least pay the minimum amount in order to get current. While a late payment history is definitely bad, currently late payments will destroy your score — pay on time!
If you're tired of paying off your credit card only to accrue more interest, try transferring your balance to a credit card with 0% interest. This way, you can make payments each month without worrying about interest payments. Check out these top balance transfer credit cards.
Signing up for credit report monitoring is a good way to view your credit reports, which lay out all of your past and current accounts in an organized way. This allows you to view all of your accounts and to catch any mistakes you may have made in the past that affected your score negatively.

5. Get a secured credit card. Having and using credit responsibly will raise your credit score, but if you are unable to get a regular, unsecured credit card because of a limited credit history or other credit issues, then a secured credit card, like the Capital One Secured Mastercard, that actually reports to the three bureaus is a great option for you. When you sign up for a secured card, you are required to provide cash collateral, which becomes your credit limit. You can then use this card as you would a regular credit card — making purchases and paying off your balance at deadline each month. For example, if you put a $300 deposit on the secured card, this is the amount you are allowed to spend.
By using a secured credit card and making payments on it  you are showing that you are responsible with credit. This will reflect well on your credit score, and if you maintain a positive payment history on the card, oftentimes the company may qualify you for an unsecured credit card. Again, you need to make sure that you sign up for a secured credit card that reports to the three credit bureaus.