If you plan to borrow money for any reason anytime soon, you’ll need to have great credit to get the best possible price and terms for your loan. Pretty much everyone knows that having bad credit will make it more expensive to borrow money, or maybe prohibit it entirely. Many folks understand that having too much debt can also hurt your chances of getting the loan you want at the price you want. What seems to escape many, however, is that you can have too little credit. You may have perfect credit, but you can have too little credit anyway to qualify for the loan you want. We call this thin credit.
Why do lenders look at credit anyway?
This concept is easier to understand if we remember why lenders look at credit in the first place. A lender wants to know that you have the ability and willingness to pay your bills on time and pay back what you’ve borrowed. You must have enough income to carry the proposed payments, some reserves to help out in case you experience a financial emergency, and a credit history that shows you are willing to make the effort to pay all of your bills on time.
Why is bad credit more expensive?
Keeping this in mind, it’s a little easier to understand what lenders look for in your credit report. The worst thing you can have is “bad” credit. (To be nice we call this bruised credit.) If you have failed to make payments on time, your credit report will show when you were late, and which debts you were late on. If you have collections, have filed bankruptcy, lost your house in foreclosure or your car to repossession, we’ll know about it.
This tells your lender two things: 1) It is likely that you will miss payments again in the future, and may not be able to pay it back at all, so the lender’s risk of losing money is higher than normal, and 2) Servicing your loan will probably require more work than a borrower with good credit, so your loan will be more expensive to service.
When a lender makes you a loan, to them it is an investment. The riskier the investment the more a lender has to charge, and additional labor has to be paid for, so you’ll spend more money on your loan if you have bad credit.
Is too much credit bad?
What if you’ve made all your payments on time, but you have too much credit? It turns out that carrying too many credit cards can hurt your score a bit, and carrying large balances on your credit cards can hurt you a lot.
If you have too many credit cards, there is usually a reason; it is likely that you will occasionally run up your balances. The credit scoring models are actually quite good at predicting who will default on loans, and statistically those who have too many credit cards tend to use them, and eventually tend to have trouble making payments. So, having too many credit cards will hurt your score and possibly raise your cost of borrowing.
If you have too many credit cards and run up the balances, however, you become an even higher credit risk because you’re that much close to not being able to make payments. Many credit analysts believe that you must keep your total balances owed to under 30% of your total credit limit between all your cards, but some opine that carrying even a small balance from month to month will hurt your score a little.
You can have perfect credit, therefore, and still be considered a credit risk if you have too much credit available
What is thin credit?
It’s obvious why bad credit will hurt your chances of getting the loan you want, and now you understand why having too much credit will do the same. But there’s one more way you can make your life more difficult when it comes to borrowing, and this one is a little harder to comprehend.
I have many clients who are very conservative about borrowing. Some avoid getting credit cards because they don’t ever want to pay a dime in interest, others simply don’t need credit and want to avoid annual charges, so they don’t open accounts.
But let’s go back to why your credit history is important. Your credit history demonstrates that you have the ability and willingness to pay your bills on time and pay back what you’ve borrowed. When you have too little credit, it might be obvious that you have the ability to make your payments and pay back your debt, but you haven’t demonstrated that you have the willingness.
Consequently, folks who have great income and good reserves will often find themselves in a position where they can’t get the loan they want. Understandably, they are flabbergasted to find out they are not considered credit-worthy (or at least not credit-worthy enough to get the best possible mortgage.)
What is enough credit?
For conforming loans you’ll want to have established at least 2 tradelines. For jumbo loans, you’ll want to have established at least three.
A tradeline is any type of debt that is reported on your credit report. The most common examples include credit cards, car loans, student loans and mortgages.
Established means that you have borrowed money and paid it back as agreed, on time, for long enough to have demonstrated that you have – you guessed it – the ability and willingness to do so. As a general rule, this means that you need to have established these tradelines for at least two years.
With credit cards, you’ll want to have used them (sparingly) and paid them off, or nearly so, every month. With an installment loan, this means you’ll have taken out the loan and made all your payments on time. You can pay it off early, but you should carry the payments for at least two years.
An ideal credit profile would probably include two credit cards and one installment loan, such as a car loan or a mortgage. They do not have to have large credit limits, but very small credit limits won’t help you much either.
If you’ve had an installment loan in the past and have paid it off, it will still help you as long as it’s on your credit report. However, the more recent it is the better, and after 7 years it will fall off your credit report, and you’ll need to establish another one.
What should you do right now?
First, is your credit really too thin? You can find out be looking at your own credit report. There are many companies on the internet that offer you a credit report and scores for free, but these companies are not the credit bureaus, and their scores are not the same as what your lender will see.
You’re entitled to one free copy of your credit report every year from all three bureaus, however. Their official site is AnnualCreditReport.com. Download your credit reports from this web site to see what the bureaus will be reporting to your lender.
If your credit is thin, there are a couple of things you can do about it. None of these are instant fixes, but all of them will help you establish (or re-establish) credit.
Apply for another credit card. If you have only one credit card, or none, apply for another card. Make sure the card is a bank card, such as a VISA, Master Card, Discover or American Express, and not a store card.
If you don’t have an installment loan on your credit report, you can probably borrow money from your bank using your car as collateral. You don’t need to borrow a lot of money to establish credit this way. A small loan of a couple thousand dollars, paid back over at least two years, ought to do it.
A mortgage is a great way to establish a credit history, but if you have to get one before you’ve established good credit through smaller tradelines you may pay a slight premium for the mortgage at first. Remember, however, that mortgages can be refinanced, often without any fees. If you’ve found the home of your dreams, don’t let a slight premium in interest rates deter you from buying your dream home. Buy your home, make payments for two years, and then refinance it.
Don’t let thin credit ruin your life
You’ve always paid your bills on time, you never run up a balance on your credit card, and you have good savings in the bank. So, you’re shocked to find out you’re not a good credit risk.
You can’t do much about thin credit overnight, but you can establish great credit in a short period of time using these smart strategies.
Your credit score and your credit profile (these are two separate things) will greatly influence how much you pay for credit. You can manage your credit just as responsibly as you’ve been managing your finances. Good luck!
Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)
Mortgage Advisor, C2 FINANCIAL CORPORATION
My Blog: www.loanguide.com
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This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.
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