Your credit score makes all the difference in your ability to buy a home and the terms you will get on your mortgage. While the credit score is designed to put a measurable quantity on your ability to manage debt, it doesn’t give the full picture of your financial health. Some hopeful homeowners confuse being financially responsible with having a good credit score, and when they apply for a mortgage find out that their credit score isn’t where they need it to be.
If you plan to buy a home in the future, here are some surprising things that can lower your credit score–even if they are actually good financial decisions over all.
Paying Off a Loan Early
It might seem counterintuitive, but paying off a loan early can sometimes hurt your credit score. Credit scores, especially FICO scores, rely on a mix of credit types—like credit cards, mortgages, and installment loans (such as car loans or student loans). The longer you successfully maintain active accounts, the more you build your credit profile, showing lenders that you can responsibly handle various credit types over time.
When you pay off an installment loan ahead of schedule, you may reduce your mix of active credit types. Closing an account can also slightly lower your “average age of credit,” which is a component in determining your score. So, while paying off a loan early is a solid financial choice that can save on interest, it can reduce your credit profile diversity and shorten your credit history, impacting your score. If you know you’ll be applying for a mortgage in the next year or so, paying off your loan early might not be the right use for extra funds.
Closing Credit Card Accounts
Paying off a credit card balance is a smart move, and some people think that the next logical step is to close the account once it’s paid off. However, this can actually hurt your credit score in two key ways: by increasing your credit utilization ratio and reducing the average age of your accounts.
Credit utilization is the amount of credit you’re using compared to your total credit limit. For example, a credit card with a $1,000 limit that carries a $250 balance has a 25% utilization rate.
If you close a credit card, you reduce your total available credit, potentially increasing your credit utilization ratio. A utilization rate above 30% can negatively impact your score, so closing an unused card with a high limit can bring this ratio up. In addition to this factor, older credit accounts help build a solid credit history, so when you close them, you may be shortening your average account age—a factor that contributes to about 15% of your credit score.
Paying off a credit card is a great thing to do, and the most beneficial move for your credit score is to leave the account open with a zero balance (and therefore a 0% utilization rate). If using the credit card is too tempting, you can take it out of your wallet and put it in a safe place, but closing the account is not the best move.
Accepting a Credit Limit Increase
This one is a little complicated. Getting a credit limit increase can often be positive, especially for lowering your utilization ratio. However, if the lender runs a hard inquiry to approve the increase, this can temporarily ding your credit score. While the inquiry’s impact is usually minor and short-term, it’s something to consider before requesting or accepting a limit increase.
Some credit card issuers offer increases without a hard inquiry, so if you’re offered an increase, be sure to ask if it requires a hard or soft pull on your credit report.
Cosigning a Loan
Cosigning a loan for a family member or friend is a generous gesture, but it will affect your credit. As a cosigner, you’re legally responsible for the loan, and if the primary borrower misses payments, it will impact your credit report as well. Even if the primary borrower is always on time with payment, the loan shows up as part of your total debt, which could influence your credit utilization and debt-to-income ratio.
While cosigning isn’t inherently a bad financial decision, and it can even help a loved one build credit, it’s a move that can backfire on your own score if things don’t go as planned. If you’re still confident that this is something you can do, just wait until you’ve settled into your own home and know your new financial scenario.
If you’re interested in learning more about qualifying for a mortgage or how the mortgage application process works, we can help. We have decades of experience helping our clients find the financing they need for their unique situation, and we’re ready to help you, too. Contact us any time to learn more.
