Credit Myth vs. Credit Reality

Do you often find yourself fielding questions from borrowers about their credit?

As a financial professional, you know there are all kinds of credit myths out there that can be confusing to people. This post addresses just a few of the more common ones and might give you some new ways to answer borrowers' questions.

Buying a home can be one of the most exciting parts of life -- shopping for houses, getting tours, checking out neighborhoods. Amid all the excitement, it's important to take some time to understand your financial position, because while buying a home can be thrilling, it's also likely to be the biggest transaction you'll ever make. 

Financially, your credit history is one of the big things that will come in to play when you find that perfect house and are ready to buy. But there is a massive amount of information and misinformation out there about credit management, which makes it tough to tell what's fact or fiction, myth or reality. 

Let’s try to debunk a few of those myths in this post.

Myth: Closing credit cards is a good way to clean up your credit report.

A lot of us have credit cards we don't use anymore, and it seems like closing them wouldn't do any harm. But the truth is, closing old cards could actually lower your credit score – substantially. When you close cards, you're reducing the amount of available credit you have, which can make your credit utilization ratio worse. And if you open a new card consolidate balances when you close old cards, you're also shortening your credit history at the same time, which is negative because length of credit history is a factor in your credit score.  

Here's a hypothetical showing how your mortgage loan could be affected: James is ready to apply for a mortgage, but right before he does he gets upset with his bank's poor service and closes his accounts, including a credit card that he used for 15 years. James goes down the street to the other bank and opens a new card. Now he has a credit card with no real history and no other active accounts - Experian says "a new, unused card represents risk." This lack of accounts lowers his credit score and leads to a higher interest rate on his mortgage.

Myth: Having no credit history is the same as having a good credit history

The reality is, you won't have a credit score at all until you have some sort of record of making payments on a loan or line of credit. When thinking about buying a house, it's important to know that many lenders expect borrowers to have at least three “trade lines” in order to be eligible for a mortgage. A trade line means any of a wide range of loans, like auto loans, student loans, or credit cards. Some lenders prefer those accounts to be at least a year old. In other words, lenders want to see that you know how to manage credit before lending you a large amount of money to buy a house, and they won't be able to know that unless you have a credit history.

Myth: It's a good idea to pay off all other loans before getting a mortgage

In reality, if you pay off all your loans in the months leading up to applying for a mortgage, then by the time of your application you could show a lack of recent credit activity. That can actually harm your credit score. Remember, lenders don't necessarily want to see that have no debt. They really want to see that you know how to make consistent, on-time payments, because they need to feel confident that you will make your house payments every month.