Q: I have been enjoying your videos on YouTube and had a question about a preapproval. My wife and I intend to try and get preapproved for a mortgage to buy our first home. We are shooting for next spring to get preapproved and then plan to begin our search after that.
We have no car debt, no credit card debt, and we just paid off my wife’s student loans. We have also paid off all of my student loans with the exception of one. It has a balance of around $3,500. I have had credit issues in the past and have been rebuilding my score for several years. I am now at a 740 FICO score.
Here’s my question: Is it better to finish paying this loan off and run the risk of my credit score dropping once the account is closed and falling below 740, or just leave it alone and apply for the preapproval as it is? The monthly payment on this loan is around $100, and our household income is around $130,000 with no other debt.
A: Thank you for taking the time to write to us, and we’re glad you have found Ilyce’s YouTube channel.
Let's start with a “congrats.” You and your spouse have done a remarkable job in paying off your debts and raising your scores. But you've made what we think of as an incorrect assumption when it comes to paying off that last bit of debt: While you may experience a temporary drop once the debt is paid off, it shouldn't last long, if it happens at all. Paying down your last remaining debt should help raise your credit score over time.
But even if you don’t have the budget or desire to pay that off right now (because you’re saving for your down payment, for example), we don’t see your current student loan debt as a problem that will prevent you from getting approved for a mortgage next spring.
Making all of your monthly payments on time will continue to burnish your credit report and score. Leaving aside your past credit “problems,” paying your bills on time (and in full, if possible) by the due date is the best way to improve your credit history.
Credit scores are comprised of five basic components: (1) your payment history; (2) how many different types of credit accounts you own; (3) what percent of your maximum available credit you’re using at any one point in time; (4) public records, like judgments against you; (5) the length of your credit history, or how long you’ve had individual pieces of credit (pro tip: the longer the better).
FICO, which pioneered the credit score, assigns different values to each of these five components. But each is important and contributes to keeping your credit history in good shape and your credit score as high as possible.
There are little things you can do beyond paying your bills on time that will help improve your credit history. For example, you should limit how much of a credit card balance you carry to less than 30 percent of your total available credit. Some credit experts advise borrowers to keep that amount to 10 percent of the available balance or less.
That doesn’t mean you can’t charge up to the maximum amount of credit you have available on a particular card, but you should pay it off by the end of the cycle. So if you have a credit limit of $10,000 on a particular credit card, don’t run more than a $1,000 to $3,000 balance month-to-month. If you’re going to pay off the card each month, then you could charge up to $10,000 and not negatively impact your credit score because you’re showing that you’re able to wisely use the credit that has been extended to you.
Longevity is also prized by creditors. So the longer your credit history, the higher your score. That’s why consumers who cancel old cards and then sign up for new accounts have lower scores over time. There’s no downside to having an open line of credit, even if you only use it once or twice a year to show it’s active. If you’re like us, having credit card accounts that have been open for 20-plus years helps your credit history and credit score.
Each month you pay your bills on time, don’t use too much of your available credit and manage your credit cards well, your credit history improves, and your credit score should reflect that. We would not be surprised if your credit score goes up 30 or 40 points by next spring if you continue paying your bills on time. Keep in mind that missing one payment could cost you 50 points (or more) on your credit score, and it could take you a year or two to recover from a late payment.
One new twist is that the credit reporting bureaus (Equifax, Experian and TransUnion) are now giving less weight to medical bills and are starting to recognize that alternative data (utility bills, cellphone accounts and even rent payments) should be part of your credit history and contribute to your credit score. While the vast majority of lenders aren’t using the official score that incorporates this sort of alternative data, they will be soon, and that can only help your prospects.
Finally, when it comes to qualifying for your loan, in addition to having a great credit score, you should save the largest amount of cash possible, so that you’ll not only have a big down payment (hopefully big enough to avoid private mortgage insurance) but also for the cash reserves the lender will want to see, plus other closing costs.
Good luck and happy house hunting.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.