In the world of financing or debt, credit scores pretty much make the world go round. The majority of lenders will always look for it whether you’re applying for a conventional mortgage or other types of home loans like VA, jumbo, FHA, and USDA.
One shouldn’t be surprised. Credit scores indicate many things to the lender:
• Your capacity to pay
• Timeliness or promptness in paying your debt
• Kinds of debt you have
• How well you use your loans
• Length of the loans
• New credit
The minimum credit scores can vary between lenders. To apply for new home loans, a homebuyer may need a score not less than 625. If they have something higher, they can qualify for lower interest rates and better payment terms overall.
Government-backed loans like FHA or VA may require a much lower minimum credit score and even a more affordable down payment. However, different fees and private mortgage insurance (PMI) can potentially offset these benefits.
Either way, because credit scores are vital when you want to access almost any kind of financing, you may want to know how mortgages can affect these numbers. Will they go up or down? If they go down, how long do they take to recover?
How Home Loans Affect Your Credit Score
When you’re applying for any type of debt, from mortgages to consumer debts like credit cards, your credit score will go down for at least two reasons.
First, these lenders will perform a hard inquiry that is, they will request to see the credit report to check your creditworthiness. Each will impact the credit score, lowering your points by at least 5 to 10 points depending on the credit. Thus, the more lenders you approach, the more likely you will experience a large drop in your credit score.
These hard inquiries will appear on the credit report and will stay there for about two years. However, since the dropped points are not that huge, you may be able to recover your credit score in two to three months.
Second, a mortgage is one of the biggest loans you will ever have in your life. Thus, both the lenders and the credit bureaus will want to see if you’re capable of truly paying it. The decline in your credit score can be as much as 40 points. Again, this depends on the value of your home loan.
You may not see your credit score decline immediately. Usually, that happens after you close the mortgage, and the lender reports it to the credit bureaus.
Because the drop is significant, it may take about six months to a year to bring the number up. For this reason, financial experts often suggest waiting around half a year before you consider getting another loan again.
If you want to hasten increase of your credit score, you can do three things:
• Pay your home loan on time.
• Maintain the ideal debt-to-income ratio, which is the proportion of your total debt to your monthly gross income. Aim for no more than 36 percent with mortgage accounting for a maximum of 28 percent of your total loans.
• Keep your credit utilization rate, which is the ratio of how much you owe over your credit limit, low as well. The ideal percentage is 30 percent or less. The best utilization ratio is between 1 and 10 percent.
How about Refinancing?
Refinancing is a process of getting a new loan to pay off the old one and take advantage of lower interest rates and more favourable payment terms. Some people think that this won’t affect their credit score, especially if they’re getting a new loan from the same lender.
However, the lender will still run a hard inquiry to determine whether you qualify for refinancing, how much you can afford to pay, and the best loan terms they will offer you. As mentioned, hard inquiries can hurt your score.
If you wish to shop for the best refinancing option, Experian suggests doing it in a short period to minimize the hit.
Sometimes the lender will recommend that you skip the last payment of your old loan since the new one will pay the rest in full. The credit bureau, though, recommends that you continue to do so until the refinanced loan kicks in. You run the risk of having a late payment, which can only drag your credit score down, in case the new loan arrives after the due date.
When you apply for a home loan or refinance it, set your expectations right: it will bring your credit score down. The good news is, more often than not, the savings and the chance of having your own home will outweigh the risks, especially if you keep up with the payments.
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