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In the before times, when we went on a date or to a special occasion, we got all dressed up so we could make the best possible impression. Likewise, when you apply for a major loan, like a home mortgage or refinance, you want to take some time make your credit report look as good as possible.
Can you quickly improve your credit score before applying for a loan? Absolutely. And when you do, your credit score can rise to new heights. I call it spiking your credit score, because that’s what it looks like when viewed on a graph.
Credit Score Basics
To understand consumer credit, there’s no need to wade into the details of debt to credit ratios and the variations between different credit scoring formulas. The two most important factors in your credit score are your payment history and your level of debt. If you’ve missed payments on your credit reports, then there’s not much you can do to quickly fix it. But if you have outstanding debt, then there’s a lot you can do to spike your score.
As the old saying goes, banks only want to loan money to people who don’t need it. Which means that the less debt you have, the more likely you are to qualify for a loan and be given the most favorable terms. As soon as you think you might be applying for a new home mortgage, refinance or other major loan, the first thing you’ll want to do is to pay off as much of your outstanding debt as possible.
The debts that you’ll want to pay off include credit cards, personal loans, vehicle loans and educational debt. Anything that appears on your credit history is something that you can eliminate to improve your credit score. And remember, you’re entitled to a free copy of your credit history from each of the three major consumer bureaus, twice a year, and only from annualcreditreport.com.
Understanding the 43% Rule
When you’re applying for a home mortgage, a refinance or another major loan, the bank will only loan you what you can afford to make payments on. And the industry standard is that you can’t receive a loan that will force you to owe more than 43% of your monthly income to debt payments.
On your credit reports, the amount of each of your outstanding debts is listed, as well as the amount of its monthly payment. Lenders will total up all of your current monthly payments and consider those payments as part of your debt-to-income ratio. With nearly all home mortgage lenders, you cannot borrow enough that your debt to income ratio exceeds 43%. So every time you can reduce or eliminate a monthly payment, it will allow you to borrow more money towards your next home mortgage or refinance. And more importantly, reducing your debt will lower your debt to credit ratio, which is an important factor in your credit score.
Paying Down a Balance Versus Paying Off a Balance
Now that you realize that reducing your debt can quickly improve your credit score, the next step is to understand how paying off a debt is different than merely paying it down. Debts on your credit history will affect your credit score based on the total amount of debt and the number of outstanding of accounts with outstanding debt that you have.
Paying down a debt reduces your debt-to-credit ratio, but until the debt is paid off, you’ll still have the same number of debts on your credit report. And unfortunately, having a large number of debts, even small ones, can negatively impact your credit score, even if your debt-to-credit ratio is low. Therefore, it makes sense to fully pay off as many smaller debts as possible, rather than to pay off a portion of a single, large debt.
For example, suppose you have three accounts, each with a $1,000 balance and one account with a $6,000 balance, and you only have $3,000 in cash. It would be better to pay off the three $1,000 account balances than it would be to pay half of the $6,000 balance. While your debt-to-credit ratio will remain the same either way, you’ll reduce the number of accounts you have with a balance, which can help your credit score even further.
Furthermore, you’ll have the most impact on your credit score when you can reduce your monthly payments made to revolving debt, like credit cards. When you pay down a credit card balance, your monthly payment goes down, until it reaches the amount of the minimum payment. But if you pay down most car loans, student loans, personal loans or other installment loans, your monthly payment will remain the same until the loan is paid in full. So paying down an installment loan won’t allow you to borrow more money towards your next home.
The Credit Card Debt Loophole
Here’s the really interesting thing about credit card debt that very few cardholders understand. About half of all US cardholders avoid interest by paying their monthly statement balances in full. These cardholders usually don’t consider themselves to have credit card debt. But according to their credit reports, they do!
Every month, when your account’s billing period ends, your credit card issuer generates a statement with your current balance. That balance is reported to the credit bureaus as debt. You may not consider it to be debt, as you plan on paying it in full by the due date and avoiding all interest charges. But from the card issuer’s perspective, you owe them money, and so it’s a debt. The card issuer will always report your total outstanding balance as debt, and even the minimum monthly payment as required by the cardholder agreement. This “debt” will reduce your credit score and increase your debt-to-income ratio, limiting the amount you could qualify for on your mortgage or refinance. This is true even if you always avoid interest by paying your balance in full.
The only way to prevent this is to pay off your entire balance just before the end of your credit card’s billing cycle. Then, your statement will show a zero balance and that information will be reported to the credit bureaus. Do this for all of your credit card accounts, and then wait until each billing cycle ends. That way, the zero balance is reported to the credit bureaus, and you’re sure to see your credit score spike.
What if You Already Have Excellent Credit?
You might be thinking that you already have excellent credit, and that you shouldn’t bother with paying off your credit card balances super early, so that your statements don’t show any debt. But home mortgages and refinances are special loans, with very high stakes. Reducing your loan’s interest rate by a fraction of a percent can save you thousands of dollars of interest over the course of your loan. In fact, having an ultra-high credit score can help you to qualify for special mortgages with ultra-low rates.
Additionally, no matter what happens, spiking your credit score can give you a little extra margin of error to account for dozens of variables in credit scoring formulas that might be out of your control, or that you might not be aware of.
A home mortgage or refinance is probably the biggest and most important loan that you’ll ever apply for. And so it only makes sense that you should do everything possible to make your credit report look as impressive as you can. And even if you already have great credit, when the stakes are this high, spiking your credit score is always good idea.
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