When applying for a mortgage, loan officers analyze your current income, lines of credit including any debt that you owe, credit scores, how much you plan on putting down for a down payment, and the sale price of the property you have fallen in love with. Lenders also require that borrowers have two years of consecutive work history. There are a few exceptions to this rule but in reality, there aren’t many ways around this particular guideline. But here is one area you have more control over where you can improve your chances of getting preapproved. Focus on your current debt and your credit score. Here are some ways you can tackle the most stressful part of your finances.
Tackling Debt and Increasing Your Credit Score
To begin, there’s no real “right” way to pay off your debt. It ultimately depends on your level of comfort but here are a few ways you can start and hit the ground running.
The first way to tackle debt is by snowballing it. Since managing money can be psychological and debt can be overwhelming, this method is one that helps you focus on paying off your debt while also creating little wins at a time. In this method, you would order all debts from smallest to largest by total amounts owed. You would pay minimum payments towards all debts but when you have extra money to throw towards debt, you would focus on paying the smallest debt off first. This allows you to see a win sooner as you pay off that account and get it out of the way. Once the smallest amount is paid off, you take the payment that you put towards that first debt and then make extra payments on the next smallest debt and so on.
A more intense way to tackle your debt is by creating a debt avalanche. Although it can be less psychologically rewarding upfront, from a mathematical standpoint you are paying less overall interest. Instead of paying off the smallest to the largest loan amount, you should order your debts from the highest interest rate to the lowest interest rate. You continue to pay the minimum on all loans, but you focus extra payments towards the highest interest rate. This minimizes the overall amount of interest you pay as you are targeting the ones with the highest rate and paying them off sooner.
A third way to look at your debt is by focusing on the loan type. Debt is not created equal. Student loans tend to be viewed as “better debt” in the eyes of the credit bureaus than credit card debt or a car loan. For this option, you would rank the debts in order from credit card debt, personal loan, car loan, and then student loans. Student loans tend to be a more accepted type of loan because the borrower takes on that debt to further their education. In a way, this can be looked at as a positive. Why? Because in theory the debt was taken on for self-improvement. It wasn’t just thrown away on some depreciating asset.
Other Factors That Affect Your Overall Credit Score
While it is important to pay off your debt, there are other variables that factor into your overall credit score. First, on-time payments are a large portion of your score. Even if you cannot pay the full statement balance, one important thing you can do is pay the minimum on time. Late payments can drop your score in a heartbeat. Utilization is the next important thing to focus on. The credit bureaus want your utilization to be at 30% or less. Utilization is the amount of credit you are using on a monthly basis compared to your overall credit limit. Age of credit history has a medium impact on your score. If you open several accounts at once, the average age of your credit history will be low. Keep older accounts open as long as possible even if you don’t use them very often. These accounts help keep your credit history mature. Finally, having enough lines of credit is essential. I see a handful of borrowers each month who do not have enough lines of credit. Although I can appreciate that you may not want to have multiple accounts open as it may encourage you to rack up debt, it’s important to keep a variety of credit lines open as it shows the lender that you can handle debt and can manage your money. If you feel tempted, stuff your credit card into your sock drawer. Having five or fewer lines of credit can negatively affect your score.
Here is the bottom line: Personal finance is personal so there’s no “correct” way to pay off debt. The first important thing to remember is that higher credit scores do get the best rate and terms. Pull your credit score up as much as possible before you apply for a home mortgage. The second thing to remember is to keep your debt-to-income percentage as low as you can. Don’t take on more than you can afford. If you are working to improve your credit, oftentimes lowering your DTI will happen as a result of your efforts.