There is no shortage of creative financing options available to investors, but the most popular way to finance a real estate investment is through a traditional mortgage.
Between 2000 and 2008, house prices soared. Banks would grant mortgages, then bundle them together into an investment called a mortgage-backed security and sell it off. Since the mortgages were backed by Fannie Mae and Freddie Mac, they were guaranteed, thus making the entire product very enticing to investors. So enticing that they were soon all snapped up, leaving investors looking for more. Banks complied by lowering their criteria for a mortgage. Remember those NINJA loans? No income, no job applicants.
People “qualified” for loans they couldn’t possibly afford, and eventually, the entire house of cards crumbled. Many of those banks crumbled, too. New rules and regulations were put into place so this didn’t happen again, and now it is pretty tough to get a mortgage. Unless you are really qualified. No more NINJAs. So what happens if you aren’t well qualified? How do you improve your credit score?
What is a Credit Score?
One of the first things a bank will look at is your credit score. Your credit score is comprised of five elements:
- Payment History
- Amounts Owed
- Length of Credit History
- New Inquiries/New Credit
- Types of Credit/Accounts
While there are different weights assigned to the different categories, using complex algorithms and predictive analytics, they are basically assigned in this order:
Payment History is given the most weight at around 35% because if you haven’t made consistent payments in the past, chances are good you won’t make consistent payments in the future either.
Amounts Owed weighs in about 30% of your total score. This category not only takes into account the total amount you owe on various types of credit — a mortgage is weighted differently than a credit card — but also takes into account the amount of debt you have accumulated compared to the amount of credit you have with that particular creditor. Having a $12,000 limit on a credit card, but carrying a $1,000 balance reads much differently than carrying a $11,500 balance on that same card.
Length of Credit History comes in at around 15%. A shorter credit history doesn’t automatically mean a lower score. You can still have a great credit score with a short history, as long as the rest of your report looks good.
New Inquiries/New Credit makes up about 10% of your score. A sudden rash of new credit cards doesn’t look very good on your score; however, several different inquiries for a home or car loan in a short amount of time usually indicates you are shopping around for the best rate.
Type of Credit/Accounts also makes up about 10% of your score. Most people are only going to have one mortgage and one or two car loans, but several credit cards. Having no mortgage and excessive credit cards could indicate lack of planning or financial sense, especially if those credit cards have a high debt-to-limit ratio.
So How Do I Improve My Credit Score?
Let’s take a look at the 5 components again.
Payment history makes up approximately 35% of your credit score, so if you make late payments, you are going to see a dramatic dip. I have had late payments myself — sometimes you just forget. But every time you forget, your score takes the hit. And while you can improve your credit score, it takes longer to bring it back up than it does to drop.
Enroll in your creditor’s auto-pay program. Most creditors have an automatic payment program, where you can either set a specific dollar amount to be paid every month (like a mortgage payment that typically stays the same for the year or a credit card that you are paying down), or specify that the entire balance due be paid on the due date (like a credit card where you don’t wish to carry a balance).
Take advantage of online bill pay. Writing a check to pay a bill is so 1990s. You have to find your checkbook, locate those stamps, and remember where you put the envelopes. Or you could simply sign up for online bill pay through your bank and make the clicks.
Pay off the debt. Let’s be frank; if the debt isn’t there to pay, it can’t be paid late.
The amount you owe also makes up almost 1/3 of your entire score, but again, this is weighted differently for the different types of credit. A mortgage is a long-term, collateralized debt, which means if you don’t pay, they can take it away. A credit card is a less stable debt — the bank can’t come repossess your pizza from last month.
This category considers your debt-to-credit ratio on credit cards, meaning the higher your balance, the lower that debt is scored. Carrying a $1,000 balance on a $12,000 limit is much better than carrying an $11,000 balance on that same card.
Really, the only way to improve your credit score under this category is to pay off the debt. Make it a top priority to get rid of as much debt as you possibly can.
Length of Credit History
The length of your credit history is a far smaller percentage of your total score. It’s nice to have a long credit history, especially along GOOD credit history, but a good short credit history isn’t so bad. Everyone has to start somewhere.
New Inquiries/New Credit
Length of credit history goes hand in hand with new inquiries — a new credit card or mortgage isn’t going to ding you as much as 9 new credit cards. If you are looking to improve your score, make intelligent choices when shopping for a new credit card. Or better yet, don’t open new cards. There are things you cannot do without a credit card, like rent a car or a room in a reputable hotel. But you only need one card.
Type of Debt/Accounts
Type of debt is also given some weight, but very little. Again, mortgage or car loan debt is collateralized, so it is safer debt than credit card debt.
Get Your Report
Under US law, you are entitled to a free credit report every 365 days. There are numerous companies that can provide you with one for free, but the site I like best is AnnualCreditReport.com. This site was set up by the three major credit reporting companies (Equifax, Experian and TransUnion) to comply with the law.
It should be noted that this site gives you a copy of your credit report for free and may charge you for a copy of your actual credit score. Those two items seem the same, but the reports contain the information — the score is determined by each individual reporting company and can vary by several points.
But the credit report is what’s really important. Get a copy of your credit report and pour over it, making sure that every single bit of information is up to date.
Are there cards still open that you haven’t used in years? Keep one for length of credit history, and then close the rest. Keep in mind that a closed account will still show up on your report, but closing an unused account will reduce the amount of possible debt you can incur.
Do you have late payment reports that aren’t true? File a dispute with the card issuer to get the information off your report.
Don’t underestimate the importance of having a good credit score. Most people use it to secure a mortgage or car loan, or to open up credit card accounts. Additionally, more and more employers are using it to assess the quality of an applicant, and a better score can be the deciding factor between two similarly qualified candidates. Figure out where you are at, and strive to improve your credit score to above 740, which will help get you the best loan rates.
Have you been successful?
Blog by:Mindy Jensent (Biggerpockets.com)