How to Build Credit as a First Time Home Buyer
So you’ve decided to take the plunge and buy your first home. This is an exciting time, and if you’ve been wise with your finances, you can be in a great position to buy. But there’s a big question: do you have the credit needed to buy a house? Often, first-time homebuyers are so financially responsible that they have managed to avoid debt altogether, and, as strange as it sounds, that may hurt you as you look for financing on a house. To buy a house, you need to have a decent credit score, but if you’ve never bought anything on credit, you may not have a credit score at all, or you may have a very thin one.
So how do you go about building the credit you need to buy your first home without making foolish decisions with your money?
Why Does Credit Matter When You’re Buying a Home?
Think of credit as a score that ranks the risk you are to the bank. If you have an excellent credit score, you are at a much lower risk than someone with a poor credit score. And, if you have no credit score at all, then you’re an unknown quantity, and the bank doesn’t know what to think about you. To them, it’s like you’re applying to college, but you don’t have a GPA to show them: they don’t know what to think about your past performance, so they’re not sure if you’re risky or not.
A credit score is a combination of all the times you have used credit to pay for something, how much people have lent you in the past, and how much credit other companies have afforded you. If you’ve never bought a car on credit, or had a credit card, or taken out a student loan, then you could very well have no credit score at all. And if all the credit cards you’ve ever had were department store cards where you’ve rarely maintained a balance, then that’s called thin credit. It’s just not enough to give the banks a good estimate of your financial future.
How Can You Build Credit to Prepare to Buy a Home?
Building credit is a process that takes time because much of it relies on credit history, not just on the current credit you have, so if you’re looking at buying a home in the future, it’s worth it to start building a credit history now. But how do you build credit to prepare to buy a home?
Apply for a Credit Card
Getting a credit card is one of the easiest ways that you can begin a credit history. How many cards you should have is an entirely different question, and that all depends on your responsibility with your spending. Credit cards tempt you to buy things like they are free money, and if you load up your credit card with a lot of purchases and carry a big balance, that could actually hurt your score.
The average American actually has four credit cards, and if you have good self-control, then four is a fine number. But for some people, four credit cards can be a gateway to major debt and credit drops.
To have the best credit score possible, it is recommended that you only use 30% of your available credit: so if you have a credit limit of $1000, then use $300 or less. This is the Credit Utilization Ratio. The credit companies want to see that you have access to a lot of credit but that you’re choosing not to use very much of it. This is a good sign that you’re wise with your money and that you don’t overspend. Even if you always make your payments on time, it will negatively impact your score if you’re using too much of your available credit.
Pay Your Bills on Time
If you have tracked payments by credit agencies, like car payments or credit card payments, always make sure you pay your bills on time. This may seem like a little thing, but payment history makes up 35% of your credit score, and if you’re late even one time, it will show up as a black mark on your report. Credit reports not only give you an overall score, but they show your entire history over the last several years, individualized for each bill. So if you were late on a car payment three years ago, it’s going to show up on a credit report. It may not be terrible if it was only one time, but it will be there. So be aware of that.
Keep Your Balances on Your Credit Cards Low, but Don’t Cancel the Cards.
As we already mentioned, you want to keep your credit card spending under 30% of the available limit, but the lower, the better. But you want to keep those cards open! If you cancel credit cards, then your available credit goes down. (If you had a credit card with a $5000 limit but carried no balance, and then you cancel it, your credit score will take a hit because suddenly your available credit is $5000 less.)
This is especially true if you’ve had the card for a while and made regular, on-time payments on it because you want that credit history to show up when someone pulls your credit report.
Keep An Eye On Your Credit Report for Errors
Your credit report can have errors, partially because of identity theft and common mistakes. You can access your own credit report at any time and look through it to make sure that everything is clean. If you find a problem, you can request to get it corrected.
Don’t Try All of This at the Last Minute
You need to plan if you want to build credit to buy a home. Getting a credit card or buying a car two months before you go house shopping will not give the credit agencies enough to go on to determine your creditworthiness. Remember: you need to have a good history of managing your money, paying on time, and keeping your debt ratio low. If you don’t have much of a history at all, it’s as good as having no credit (or being “credit thin”). So while you’re saving money for that down payment on a house, which will undoubtedly take some time, get a few credit cards and make sure that you use them wisely.
How Good Does Your Credit Score Need to Be to Buy a Home?
As a rule of thumb, you need to have a credit score of at least 620 to qualify for a home loan. You can get some loans if you have lower credit, but that doesn’t mean you should take those loans. Generally, when you’re a credit risk, you’re not going to get very favorable terms, meaning you may need to put more money down, and you’ll have a much higher interest rate. You’ll be better off (usually) waiting a few years to repair your credit than to take a bad loan.
Is it Possible to Buy a Home Without Credit?
Yes, it is possible to buy a home without credit, but it has to be under very certain circumstances, and there will be outer hoops you need to jump through.
What You Need to Buy a House with No Credit
If you have no credit history, the loans that you want to look for are FHA loans, VA loans, and USDA loans. They’re going to look pretty hard at the following items:
Steady Employment History
It would help if you showed that you have a good employment history, not jumping from company to company, or having long periods of unemployment. Essentially, these lenders don’t want someone who just got a high-paying job to run out and buy a house without having financial stability.
Steady Income on Your Tax Returns
Like the above, the lender will want to see your tax returns to ensure that you’ve had a steady stream of income over the years. This is the closest thing they can get to credit history.
Savings for the Down Payment and Closing Costs
If you’ve got no credit, you’re definitely going to need a full down payment and money for closing costs. While there are loans out there that let you get a home with as little as a 3% down payment, you’re not going to get that with no credit history. Expect to need at least 15-20% down payment (there are exceptions to this, as we’ll see with the FHA loan below).
Most lenders also want to see that you still have money in the bank after you’ve paid for the house. Some want as much as six months’ worth of expenses saved up, but that number fluctuates. Basically, they want to be sure you’re not going to overspend on the house, immediately run out of money, and not be able to pay your mortgage.
FHA Mortgages, VA Loans, or Co-Signers
The FHA (Federal Housing Administration) says on their website that “The lack of a credit history, or the borrower’s decision to not use credit, may not be used as the basis for rejecting the loan application.” Instead, lenders will look at the things mentioned above to make the decision. Note: the FHA loan is only for first-time homebuyers.
One big benefit of an FHA loan is that lenders can give loans to people with as little as 3.5% down payment.
The Department of Veterans Affairs, VA Loans, says, “There is no minimum credit score requirement [for a VA mortgage]. Instead, VA requires a lender to review the entire loan profile.” Similar to the FHA loan, a VA loan can require a very low down payment—even a 0% down payment in some circumstances.
The final way to get a home with no credit history is to use a co-signer. A co-signer is someone who has good credit who is basically committing to taking on the burden of the loan if you default. While it can be tempting to ask parents or other family members to co-sign on a loan, be certain that you’re not taking advantage of a close relationship. If you run into financial difficulty, you could ruin the relationship if they have to take the weight of your mortgage on their shoulders.
In conclusion, the best way to build up credit for buying a house is to carefully plan to buy while you’re saving money and applying for credit cards or buying a car on credit. Ensure that you always pay your bills on time and don’t let your credit card balances get more than 30% of your limit.
And, if you qualify, trying an FHA or VA loan could be a good option for you.
Are you ready to move into your first home?