How Does Buying a Home Affect Credit?
Homeownership is a dream that many people have. Buying a home can be the start of the foundation for the rest of your life. However, buying a home comes with many stressful elements. Moreover, a home is a huge expense, and it will influence many aspects of your financial future. As a result, many people have been wondering how buying a home will affect their credit score.
Credit scores are important numbers. They determine whether you can qualify for financial products like loans and credit. Your credit score also determines what kind of interest rates and terms you’re offered on different financial products. Therefore, it’s important to understand how owning a home can influence your credit score so you can know what to expect and plan for your financial future.
Buying a home with a mortgage is a complex process. Therefore, it should come as no surprise that home ownership doesn’t just have one impact on your credit score. Moreover, the effect that home ownership has on your credit score changes over time. We’ll look at the different ways buying a home affects your credit score in the short, medium, and long terms.
Short Term Impacts of Buying a Home on Credit Scores
When you initially finish up your mortgage negotiations, finished the inspections, and finally close on your house, you’ll be in a mood to celebrate. This makes all the sense in the world, as you’ve achieved a huge accomplishment in life. However, oftentimes people will see their credit score right after buying their home and decide that they can never celebrate again.
When you first buy your home and take on a mortgage your credit score will suffer a drop. This happens because you now have much more debt than you did before you took out a mortgage. As a result, several of the most important factors for determining a credit score change. The biggest example of this is your debt to income ratio.
A debt to income ratio compares the total amount of money you owe to the amount of money you make in a year. Buying a home and taking on a mortgage establishes a disproportionate amount of debt. Therefore, your debt to income ratio will be negatively influenced, and your credit score will drop.
However, you shouldn’t let this drop sour your mood. The drop you get from taking on a mortgage will only be temporary. Credit scores are a way of calculating your ability to pay back debt. Once you start making payments on your mortgage and show that you have the ability to meet your obligations your score will start edging up again.
Medium Term Impacts of Buying a Home on Credit Scores
In the medium term, your credit score will be improved by your mortgage, assuming you make on-time payments. Mortgages can improve a credit score in a few different ways. First, a record of on-time payments will show that you can be relied upon to pay back your debts. Second, a mortgage is a type of debt called installment debt. Installment debt comes in the form of loans that you pay back. It stands in contrast to things like credit card debt, which is considered to be revolving debt.
Revolving debt influences your credit score in a different way than installment debt. Revolving debt opens a line of credit you can use, but don’t have to use. Therefore, the amount of this revolving debt that you’re using serves as an indicator as to your ability to pay debt back. Ideally you’ll be able to keep your revolving debt utilization under 25%. If you have $10,000 of total limit across your credit accounts, you’ll want to be sure that your total balance is under $2,500.
One of the ways that the credit reporting agencies determine your credit score is based on the mix of credit accounts you have. Owning a home is considered a responsible form of credit. Therefore, it will make the mix of credit accounts you’re using better. The result of this improved mix is an increase in your credit score.
Long Term Impacts of Buying a Home on Credit Scores
In the long term, owning a home will boost your credit score. This is especially true once you’ve paid off your mortgage or established equity in your house. When you’ve established equity in your home then you have an asset that you can, in theory, use to pay off debts. This increases your ability to meet your obligations and therefore improves your credit score.
Additionally, once you’ve paid off your mortgage then your debt obligations fall off dramatically. Because you own your home you don’t have to pay rent. Moreover, since you’ve completed paying off your mortgage you no longer have that payment to make every month. As a result, your debt to income ratio will benefit greatly, and you’ll have a much greater capacity to pay your debt off. Therefore, your credit score will climb.
As you can tell, there are many different ways that owning a home and taking out a mortgage can influence your credit score and credit history. Make sure you keep your eyes on the prize and focus on getting the best long-term results from your mortgage. Paying off your mortgage as quickly as you can will allow you to improve your debt to income ratio, establish equity faster, and shows that you’re able to meet your financial obligations. All of these things work to give your credit score serious improvement. Moreover, paying your bills on time will establish a solid credit history and will help your credit score improve.
Don’t let the initial shock of a lowered credit score when you first buy a home get you down. Owning a home is still a huge achievement, and is still worth celebrating, if not for the fact that you own a home itself, then for the benefits that you and your credit score will reap in the future as a result of your purchase. Just make sure to pay your bills on time and you’ll be enjoying all the advantages of owning a home in no time.