Even with interest rates at historic lows, there can be a big difference in the rate you'll be charged if you have good credit and not-so-good credit. How much? The difference over the lifetime of a 30-year, $200K mortgage can be $67K. That's a serious chunk of change.
There are two metrics that home lenders will use to determine whether or not to approve your mortgage: debt-to-income (DTI) and credit score. If you're thinking about buying a home or refinancing, you should look at how you measure up and start cleaning up at least a year before.
DTI is a measure of capacity, or how much debt that your lender things you ought to be able to support based on your income. The traditional guidelines are that your housing payments should not come to more than 28% of your monthly income and that total debt payments (including auto leases, child support and alimony) not come to more than 36% of you income after your new mortgage payment is added in.
Related: Everything you need to know about VA Home Loans
You can clean up your DTI by paying off low-balance loans before you apply for a mortgage. For example, if you only have a few months left on an auto loan, you'll improve your DTI more by paying that off than by putting the same amount against credit cards. If your DTI will be over the guidelines, focus on paying off credit cards to reduce the monthly amount needed to service your debts.
Your credit score is a number given by a mathematical model that looks at all your credit data and payment behavior. Negative actions "age" off over time, becoming less important as you go back in time, which means that you'll have time to actually impact your credit scores if you give yourself enough time.
These five steps can help you whip your score back into shape in less than a year.
1. Check your credit report for inaccuracies on annualcreditreport.com, a free site run by the bureaus. If you do have inaccuracies on your report, follow the dispute process outlined.
2. Check your score: you can get this for free at CreditKarma.com or Quizzle.com. Generally, they will also show you how you compare to others and what areas might lower your score.
3. Pay off toxic accounts: rent-to-own and in-store financing are toxic. They hurt your credit score much more than other types of debt. Do everything you can to pay off and close these types of accounts as soon as you can.
4. Pay all accounts on time: this is the single biggest component of your credit score. If you've had difficulty in the past, 6 months of consistent on-time payments can have a big impact on your score.
5. Reduce your credit utilization: ideally, the ratio of your outstanding credit card balances to credit line should be less than 20%. If yours is high, pay off as much as you can before applying for a mortgage. Closing paid off accounts can actually hurt your utilization (by reducing the available credit line) so don't close paid off accounts unless there's an annual fee or it is in-store financing or rent-to-own.
Following these steps can help you whip your credit into shape in time to get a new mortgage at a better rate.
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