Get your finances in order

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At this point you've learned what it takes to buy a house. Now
it's time to get prepared to do so. Here's your financial checklist:

1. Pay down your debt. The bank wants your total debt to be no more than about 38% of your
income. If your income is $3000/mo. then the bank figures your total debt can be $1140/mo.

But if you already have $1000/mo. in debt, then you have only $140/mo. left for mortgage

payments. Pay down your debt as much as possible to increase your borrowing power. Pay

down the highest-interest debt first (credit cards) before lower interest debt (car loans,

student loans).

Once you pay off your credit cards get in the habit of paying them off every month and never

carry a balance. Few things can kill dreams of home ownership better than credit card debt.

Pay down that debt! If you have a hard time paying down your debt then use the technique

advocated by Charles Givens: Pay Yourself First. Every time you get a paycheck, take a

portion of that paycheck and apply it towards your goal of paying down your debt first. If you

wait to take care of everything else first you may never have anything left over to pay down

your debt with.

There's more about how debt holds you back in our sections on the Debt Ratio and How Much

Loan Can You Get?.

2. Get the down payment together. If you don't already have a down payment saved, start
saving now. If you have a hard time saving then use the Pay Yourself First technique

mentioned above: Every time you get a paycheck, put a portion in your savings account first.

Pay yourself first so that money is definitely saved. It may help to have a separate account for

your down payment, so it's easy to see its size completely separate from any other savings

you may have. Remember, having a sizable down payment is the #1 factor in being able to

qualify for a loan -- especially being able to qualify for a bigger loan.

3. Clean up your credit report. Good credit not only helps you qualify for a loan in the first
place, it helps you get a better deal when you do get a loan. This is a big topic so we cover it

on its own page, next....

 Credit Reports & Credit Scores
« Back: Get your finances » Next: Repairing credit, Establishing credit, Problems caused by bad
in order « or Find a lender » credit
As I write this in June 2009, you generally 1. Inability to get a loan
2. Higher interest rate if
need a credit score of at least 660 to get a you do get the loan
3. Larger down payment
mortgage. Not too long ago you could get a loan with as required if you do get the loan

little as 580, but banks are more cautious these days because of
the mortgage crisis (which was caused by lending to folks with
low credit scores who ultimately defaulted on their loans).

Your credit score doesn't just dictate whether you can get a loan, it
also impacts how good an interest rate you get. The worse your credit score,

the higher the rate of interest. You might also have to have a larger down payment than otherwise.
This bears repeating: Bad credit doesn't just mean you might not get the loan in the first place, it
means that if you do get the loan, you'll have to pay more interest, and you'll be required to make a
larger down payment.

Here's an example from MyFico.com in June 2009 about how credit scores might affect the interest
rate -- and therefore the cost of the loan -- on a 30-year, $200,000, fixed-rate mortgage.

Interest Monthly
Credit Score
Rate Payment
760 - 850 5.26% $1,540
700 - 759 5.48% $1,567
680 - 699 5.66% $1,589
660 - 679 5.87% $1,616
640 - 659 6.30% $1,670
620 - 639 6.85% $1,741
Payment based on $200k home, 5% down, PMI, closing costs rolled into mortgage, includes estimated taxes + insurance.
Loans are not generally available to those with credit scores below 660.

Consumer Reports also addresses this topic, saying, "Over the life of [a $150,000] loan, the people
with the best credit scores may pay roughly $138,000 less than those with the worst."

The higher your credit score, the less you'll pay for your mortgage. The lower your score, the
 more you'll pay. It's therefore important that you improve your credit score if it's low.

Average credit
scores
The median U.S. score is 723. Here's how the
American population's credit scores stack up.

Percentage of
Credit Score population
with this score
800+ 13%
750 - 799 27%
700 - 749 18%
650 - 699 15%
600 - 649 12%
550 - 599 8%
500 - 549 5%
less than 500 2%
From MyFico.com, Aug. 2006

Credit Report vs. Credit Score

Your credit report and your credit score are two different things. Your credit report is a list of
things like your credit card and bank accounts, outstanding loans, and your payment history. Your
credit score is a rating of how good your credit is, based on your report. In other words, your credit
report is a bunch of pages, and your credit score is a number from 300 to 850.

The main things on your credit report that hurt your credit score are:

 Bankruptcy
 Outstanding (unpaid) debts
 Late payments
 Credit card balances near the credit limit on those cards
 Liens (both outstanding and paid)
 You increase your credit score by cleaning up your credit report. The score is based on the report, so
get a clean report, and you'll have a good score. We'll cover cleaning up your credit report later, but
for now let's continue learning about your report and your score.

You actually have three credit reports

The companies that keep track of your credit report are called credit reporting agencies
(CRA's) or credit bureaus. There are three of them: Trans Union, Equifax, and Experian. So you
actually have three credit reports, since there are three CRA's that track your credit. They're usually
very similar (often nearly identical), but sometimes they can differ. For example, most credititors
report late payments to all three CRA's, but some might report late payments to only one or two CRA's
rather than all three.

This means that if you need to clean up your credit report, you probably have to clean up three
different credit reports. You never know which CRA your lender is going to consult about your credit
(although some lenders will tell you if you ask). Many lenders consult all three CRA's, too.

You can get your own reports yourself because by law each CRA has to give you a copy of your report
once a year if you ask for it. You start out at AnnualCreditReport.com which in turn sends you to each
of the three CRA's websites. But be careful! These sites often make it hard to see how to get your
report for free, while they put misleading come-ons for paid services right in front of you (free for the
first 30 days after which they bill you every month). Many people sign up for these accidentally,
thinking that that's what they need to do in order to get their credit report from the site. You can
really get your reports from these sites for free, but you might have to hunt a while for the right
options.

Also beware that these sites will generally try to sell you fake credit scores -- scores that are
completely different from what your lender actually uses. To protect yourself against that, let's learn
more about credit scores.

Kinds of credit scores

The most common kind of credit score is the FICO score, which is calculated by a company
called Fair Isaac. Fair Isaac makes its money by selling the FICO scores on individual consumers to
banks. When your bank buys a credit report from a CRA like TransUnion, it also buys the FICO score
 calculated from the TransUnion report. Since you have three different credit reports, you also have
three different FICO scores. In fact, your bank might order all three scores.

While the FICO score is the most common, the three CRA's each have their own scores that
they try to sell to the banks. TransUnion sells a "TransRisk" score and Experian sells a "ScoreX"
score. Banks generally use the FICO score because it's the industry standard, but some banks might
go with the CRA brand because it's cheaper.

Many banks have also devised their own system to calculate credit scores from credit
reports. That way they don't have to pay anyone for the credit score.

So there are potentially seven different scores your lender might see:

 The FICO score from the three CRA's

 The proprietary score from the three CRA's
 The lender's own internal score

So why is this important? Because if you're checking your credit score(s), you need to make sure
you're looking at the same one(s) your lender sees! The best way to find out what scores your lender
uses is to ask them -- they'll generally tell you. If you don't have a lender in mind yet, then get
genuine FICO scores, because that's what most banks use.

Getting your credit scores

Paying for them

You should usually get your three real FICO scores before applying for a loan. It'll set you
back $48, but that's a minor cost in the scheme of a $150,000 home. There is only one place to get all
three FICO scores at once, which is MyFICO.com.

You could get just the FICO score based on your Equifax report for $16, which is okay only if you know
that that's the only score your lender is going to look at. If you don't know which score they're pulling,
it's better to get all three.

You can't buy your FICO scores based on your TransUnion or Experian scores separately, because
nobody sells them directly to consumers. Any such scores you see advertised are proprietary scores,
 not true FICO scores.

Beware of sites offering "your credit score", since 99.9% of the time they're not real FICO
scores. Remember that nobody offers all three genuine FICO scores directly except MyFico.com.

Getting them for free

You can ask your lender for your score(s) once they've run your credit. Getting your credit
scores after you've applied for a loan is kind of like putting your seatbelt on after you've already had a
wreck, but if you've already applied for a loan, your lender will often tell you your score if you ask. In
fact you should ask for a copy of the whole report(s), so you can get an idea of what the problems are
if your score is low. Most lenders make you pay for the report(s) before they order it, and if that's the
case and they won't share it, point out that you paid for it, not them.

Of course, if the lender already approved your loan and you got a great interest rate, then your credit
score is kind of a moot point. But if you didn't get the lowest rate possible, then you'll want to shop
around at other lenders, and in that case you need to know what's on your credit report to see if you
can clean it up to improve your score. (More on that later.)

Another possible way to get a free FICO score is through your credit card company. Most
cards don't offer this service, but some do. For example, with my Washington Mutual card, I can login
to my account online and see my FICO score based on my TransUnion report. The problem here is
that you can't see the other two FICO scores, and if you're making an investment as big as buying a
house, it's best to cover all your bases and get all three.

Do I need to improve my credit score?

That depends on how good your credit is, of course.
Excellent credit. If you know that each of your FICO credit scores is 760 or higher, your credit is
excellent and there's no need to try to improve your score.

Good credit. If your FICO scores are between 700 and 759, then you have a choice: cleaning up you
reports and getting your scores about 760 will get you a slightly higher interest rate, but not much.
(See the table above.) So it's up to you whether it's worth your time in trying to improve your credit
rating.

Myth: Checking my credit score or getting
Fair to Bad credit. If your FICO scores are less than 700, or if you don't know your scores but you
FACT:
have your credit reports and can see that they list negative items,
your credit. That's our next item.
This page will tell you everything you
need to know about improving your
credit score. If you haven't already read my
introduction to Credit Reports & Credit Scores, I strongly
suggest you read that first.
How to improve your
credit score
As you know from the Credit Reports & Scores page,
you improve your credit score by cleaning up your
credit report. Below are the tried-and-true ways to clean
up your credit report. This is truly everything you need to
know. Don't pay for credit repair services, because they
can't do anything for you beyond what's listed here.
Late payments & collections
       Don't make any (more) late payments. Make sure
you pay every bill on time from here on out. Taking steps
to bring your score up does you no good if you do things
that send it right back down. Also, the older a late
payment is on your credit report, the less it hurts you. So
a late payment you made last month hurts a lot right now,
but in two years that same late payment won't hurt your
score as much. If you make no more late payments, your
score could improve 50 points within a year.
Credit scoring
myths
my credit report hurts my credit score.
No, itit's
then doesn't.
time Inquiries
to startabout your
rebuilding
report for the purpose of establishing new
credit can decrease your score a little bit,
but inquiries to just get your score or a
copy of your report never hurt your score.
And even though inquiries for the purpose
of establishing new credit reduce your
score, they don't reduce it by very much.
Myth: Closing credit card or merchant
accounts will help my credit score.
FACT: Closing accounts generally won't
raise your score. People have heard, quite
correctly, that sometimes having too many
open accounts can hurt your score. That's
true, but once you already have the open
accounts it's too late. If you close accounts
now then your ratio of outstanding debt to
credit available will rise, which will probably
negatively impact your score.
Now, if your lender asks you to close an
account or two as a condition of getting the
loan, then go ahead and do so. You're not
doing so to raise your score, because it
doesn't, you're doing so because your
lender says that what it takes for you to get
the loan. The reason they might do this is
because they're afraid if you max out all
your various cards you'll be spread too thin
and won't be able to pay back the
mortgage. So they may want you to close
an account or two to reduce your ability to
rack up more debt. But you should close
accounts only if your lender says you need
to do so in order to get the loan. If a
mortgage broker suggests you do so,
ignore them.
         Pay off collections. If you have a delinquent account, pay it. That won't remove it from your
credit report, but it will still help your score, because a late payment is not nearly as bad as an unpaid
debt.

        Correct errors. If there are any errors on your report (such as late payments when you weren't
late), write a letter to the CRA in question and ask that the error(s) be removed. The CRA has 30 days
to investigate; they'll write to the creditor and ask them to verify the payment info. If they don't, the
CRA will remove the negative info from your file.

        Make sure negative info older than 7 years isn't reported. By law, negative information in
your credit report must be deleted after seven years (10 years for bankruptcy). If your report contains
negative info that's more than seven years old, write the CRA and ask them to remove it. Also note
that if you missed a payment 8 years ago, but it took the creditor 2 years to report it to a collection
agency, it will likely show up on your report as a 6-year-old debt. In that case, write to the CRA and
explain that the debt is really 8 years old and should be removed. Include a copy of any paperwork
that supports your claim.

        Add your side of the story. If there is negative info in your report (such as non-payment of a
debt), but you have a good reason for not paying the debt (merchandise not received, legitimate
dispute with the merchant who would not negotiate in good faith, etc.), write to the CRA and ask them
to add your short explanation about the matter to your file. If the lender pulls your credit report they
might see the statement you added. They might not see it, because some lenders just look at the
credit score and don't scrutinize the report itself too closely, but it couldn't hurt.

Paying down debt

        Pay down loans. The more debt you're carrying, the lower your score. Your debt is evaluated in
comparison to the total credit available to you. So $1000 of total debt with a $1500 total credit limit
(1000/1500 = 67%) is probably worse than $3000 of debt with a $10,000 limit (3000/10,000 =
30%). So pay down your debt to increase your score.

        Once I made a single $11,340 purchase on a card with a $12,000 credit limit. Even though my
total credit available was about $188,000 on all my cards and I had only a few thousand dollars
outstanding on my other cards, that one purchase near my credit limit on that card plunged my scored
nearly 70 points from 825 to 757 in a single month. However, once I paid off that charge, my score
zoomed right back up by 68 points the very next month.

The power of time

         Wait. Credit scores get better with time, just like wine. The older a late payment is, the less it
hurts you, and the older a credit card account is, the more it helps you. If nothing else changes, your
credit score will gradually creep up on its own.

Getting credit if you don't have any

        Get and use a credit card. In most cases you need to have (and use) at least one credit card
in order to have a good credit score. If you don't have one, get one. Just use it to buy your groceries,
and pay it off in full every month. Here's more on getting a credit card.

Ignore everything else

        Ignore most other advice you hear. Myths about

what actually helps or hurts your credit score would fill a
book. Some of them are listed in the sidebar above. Some
of them are even espoused by people whom you'd think
would know better, like mortgage brokers. But the list
you're reading now is all you need to focus on. Be
skeptical of any other advice you may hear about how to
improve your score. If it sounds legitimate and you want to believe it then try to verify it first
somehow, don't just accept it on faith. Because taking bad advice might not just fail to improve your
score, it could actually hurt it. Really, just correct errors, get old negative items off your report,
maintain a good payment history, and don't max out your credit, and that's pretty much all you need
to do.

        Don't pay for credit-rebuilding services. The tips in this section are everything you need to
know about rebuilding your credit. There isn't anything else. Nobody can do anything more for you
than what I've listed above. Don't throw your money away on credit repair services.

Examples of credit score improvement

Here are some concrete examples of how various actions could affect a credit score of 670
in either direction. This came directly from the MyFICO simulator in 2008, except for the item about
maxing out your credit, which I estimated from my own experience.

How various actions affect a credit score of 670

 New Credit Score
Action

730-770
Pay off all of a $2100 outstanding balance

710-750
Pay down 2/3 of a $2100 outstanding balance

670-710
Pay down 1/3 of a $2100 outstanding balance

685-725
Consolidate balances onto a new card with a $5000 credit limit

675-715
Consolidate balances onto a new card with a $1000 to $3000 credit limit

690-720
Pay all bills on time for next 12 months

690-720
Pay all bills on time for next 6 months

670-690
Pay all bills on time for next 3 months

610-645
Pay a bill late

580-620
Max out your credit (charge $11,000 to a card with a $12,000 limit)

500-550
Declare bankruptcy

Note that another way to say "Pay all bills on time" is simply, "Wait." Paying promptly is the same
thing as doing nothing bad. If you're not doing anything to sabotage your report, then you're basically
just biding time. And as time passes, your credit score will go up. A lot.

Should I wait for an item to expire off my

report before I apply for a loan?
Late payments are removed from your credit report once they're over 7 years old.
Bankruptcies are removed after ten. If it's only going to take a few months for a negative item to
expire off your report, and you don't have a specific dream house in mind that you want to buy right
now, then sure, go ahead and wait for the bad item to expire before applying for a loan, so you'll have
a higher credit score and get a better interest rate.

But what if you have found your dream house that's on the market right now? If you don't
buy it now, someone else will probably buy it while you're waiting for your credit report to improve. In
 this case, figure out how much extra you'll pay because of the higher interest rate, and see if you're
willing to pay that premium in order to get your dream house. And remember that once your score
improves, you can always refinance at a better rate later on.

If it's going to take a couple of years for your credit score to improve, and you're able to get
a loan now, you should probably do so rather than wait. Yes, you'll pay more interest, but you'll
start your investment in your house that much sooner, which will balance out the extra interest you'll
pay. And once your credit score improves, you can always refinance at a lower rate.

Links
MyFICO offers a credit education center and some interesting credit statistics.

Establish Credit if you Don't Have Any

« Back: Credit Reports & Credit Scores, or Repairing your credit « » Next: Find a Lender »

Bad Credit is a lot worse than No Credit, but you should still seek to establish some credit if
you don't have any. You may be able to get away with having no credit history if you're getting an
FHA loan (vs. a conventional loan), but still, it never hurts to have credit.

Credit cards and bank loans are just about the only things that will show up postively on your credit
report. Other items like utility bills and rent payments usually DON'T appear on your credit report to
show that you've paid them on time; they only show up when you DON'T pay on time. They can't help
you, they can only hurt you. Yeah, it's not fair, but what are you gonna do?

What you're gonna do is at least get some things on your credit report that CAN help you.
You want at least two items on your credit report: two credit cards, or a credit card and a bank loan
(like a car loan). Of course, don't rush out and buy a car just because you don't have a car loan; it's
easier to just get two credit cards. The primer below will help you do this.

Getting a Discover Card

Discover is one of the easiest cards to get. Just call 1-800-DISCOVER, they'll ask you some basic
questions like how much money you make, and you have to make only $15,000 a year to qualify, as I
write this in fall 2006. And if you're a college student then there is NO minimum income requirement.
(I got my card when I was a student, but they didn't ask for any documentation to prove I was.) After
answering the questions, you'll get an answer on whether you were approved for the card in just a few
days.

Getting a Visa or MasterCard

While the Discover card is available from only one source (the company that owns Discover), Visa and
Mastercard are issued by individual banks -- so there are hundreds of places to get a Visa or
Mastercard -- and if one turns you down there are plenty more.

Start with the bank that carries your checking or savings account. Just go in and ask for a credit card,
and they'll see if you qualify. If you have a Visa check card or debit card on your checking account,
that does NOT count as a credit card and doesn't show up on your credit report; you'll need to obtain
a credit card separate from that. Your bank probably won't ask why you want a credit card when you
already have one on your checking account, but if they do just be honest: You're trying to establish
credit. (Or, it may be that you want to charge more than you currently have in your checking
account.)

If your bank says you don't qualify for a credit card, then ask for a secured credit card. This means
you put money into an account (often a savings account) and you can charge no more than the
amount in the account. It sounds like a Visa check card on a checking account, but the difference is
that this is a "real" credit card and shows up on credit reports to help you build credit. (Some secured
cards don't help you build credit, so make sure you ask your banker if their secured card will.)

If your bank doesn't offer secured credit cards, find another bank. There's almost certainly a bank in
your area which offers them. You can also search for them on the net.

How to use the card

Your goal in getting a card is to prove to a home lender that you pay your bills on time, so that's what
you should do: Use the card and pay your bill on time. If you never charge anything to the card, it
won't help you much. And if you use it but don't pay your bill on time, then that's worse than not
having a card at all.

How much should you charge? The amount you charge isn't
as important as the fact that you're charging something and
that you pay your bill on time. Of course, you don't want to
be making frivolous purchases just because you want to
establish credit. Probably the easiest thing to do is to just buy your groceries with your card,
and to restrict yourself to buying ONLY your groceries with it (especially if you're worried that
you might not be able to control your card spending). When you get your credit card bill each month,
pay it off in full. This has other benefits besides establishing credit -- you don't have to fiddle around
with writing checks when you go grocery shopping, you'll have fewer entries to deal with in your
checkbook, and it'll be a lot easier to see how much you're spending each month on groceries if all
your groceries are on your credit card bill and nothing else is.

By the way, credit reports list both how much your average balance is and how much you pay each
month, so charging $5 each month and paying it off isn't going to fool anybody -- but doing that
would still be a lot better than charging nothing at all.

Credit card interest

As long as you control your spending and pay off your balance in full each month, there's
nothing to fear from credit cards. If you pay off your balance in full, you don't have to pay any
interest on your purchases -- not one cent. This is how you should use a card.

Card companies hope that you WON'T pay off your entire balance and that you'll just make
the "Minimum Payment" listed on your credit card bill instead. It looks so enticing -- if your
credit card bill is $1000 you can make a minimum payment for perhaps just $20. And the next month
you can pay just $20. Paying $20 certainly seems a lot more attractive than paying $1000.

Here's why you should never make the minimum payment: It will take you forever to pay off
your card, and you'll pay interest out the wazoo. If you make the minimum payment on a $3000
balance with 20% interest, it will take 31 years to pay off, and you'll pay a total of $12,000! (And
yes, credit card interest is around 20%.)

The moral of the story is: Pay off your balance in full every month. If you've gotten yourself
into debt and you can't pay off the whole balance, then pay at least double or triple the minimum
payment. (In the above example, doubling the minimum payment cuts your payoff time down to 6
years and $4600 total.) If you have multiple cards, pay more aggressively on the cards with higher
interest rates.

Don't take cash advances

You don't pay any interest on purchases if you pay off your balance when you get your bill, but if you
get a cash advance on your card, you start paying interest from the millisecond you get the money --
PLUS you pay a cash advance fee. Never take a cash advance on a credit card unless it's an
emergency.

Debt shifting

As soon as I bought my first house, banks started mailing me all these offers for free gold and
platinum credit cards. So I signed up for about five of them. I didn't use them, but I thought they
might come in handy someday. I was right.

A few years later when I was getting ready to sell the house, I didn't have the cash to make all the
improvements I'd planned, so I put about $10,000 on a few of the cards, figuring that once I sold the
house I'd be able to pay the balance off in full. In the meantime, while the work was being done and I
was waiting for a buyer, I got an offer from one of the cards I hadn't used for me to transfer my
balances from my other cards and pay only 5% interest for six months. Great, I readily transferred my
balances to the unused card.

I sold the house, but since the interest rate was so low, I didn't pay off the balance right away. Then I
got an offer on one of the other cards to transfer my balance there, for 3% for five months. So I
transferred my balance there.

I finally realized that I was making money by holding onto the credit card debt! I could take $10k out
of my investments and pay off my credit cards, but that $10k was making me 10-30% in socially-
responsible investments. By paying off the cards I'd be giving up 10-30% in order to save 5%. So I
held onto the debt, and simply kept shifting from one card to the other for years. In the rare event
that I didn't get a mail offer for a balance transfer from one of the cards, I'd just call up the card
company and ask for a low balance transfer offer, and they always gave it to me. I also asked them to
waive the balance transfer fee, and they almost always obliged. For years I never paid more than 5%
on my debt. I didn't pay it off until I sold off my investments when the stock market tanked in 2001.

Note that debt-shifting is risky, since the stock market is unpredictable. If you wind up losing money
in the stock market, then you've not only lost money, but you've had nothing to offset the interest on
your credit card balances.

Under 18?
 If you're under 18 then you won't be able to get a credit card, but you might be able to get a bank
loan if your parents co-sign for you.

How to figure how much of your payment goes to interest

An advanced topic for the curious: When you make your payment, how much goes to interest? Just
take your balance and multiply it by the interest rate divided by 12. (There are 12 months in the year,
and you want to figure only the monthly interest, not the yearly interest.) If your balance is $3000
and the interest rate is 20%, then your monthly interest is $3000 x (20%/12) = $50.

How is the minimum payment figured? It's usually 1/48th of your balance, or $20, whichever is
higher. So your minimum payment would be $3000/48 = $63. So if you make the minimum payment
of $63, then $50 will go to interest and only $13 will go towards paying down your balance. After
making this $63 payment your outstanding balance will be $2987. Ouch.