How to Prepare Your Credit for a Mortgage

Applying for a mortgage soon? Consider this: Improving your credit health could limit how much you'll need to pay in interest and potentially save you thousands of dollars.

According to Zillow, the median home value in the United States is $178,500. Let's pretend that two people each want a $178,500 30-year fixed mortgage and have the same amount saved up for a down payment. However, one has an excellent credit score of 760 while the other has a poor score of 620.

How much more do you think the person with the poor credit score will have to pay?

In most cases, poor credit could cost that consumer tens of thousands of dollars. Even the seemingly minuscule difference between a 3.5 percent interest rate and a 5 percent interest rate could tack on an extra $59,000 or more over the life of the mortgage, according to FICO's loan savings calculator. (Keep in mind, interest rates and savings can vary and are ultimately up to the lender.)

It's clear that your credit is important. Let's discuss a few ways to prepare your credit in the months or years leading up to your mortgage application:

1. Monitor your credit score.

Your credit score will likely be one of the most important aspects of the approval process. Don't go into the mortgage process blind. Instead, check your score ahead of time so you can estimate what kind of rates you may get and whether your credit is good enough to get you approved. Then, identify areas of your credit history that need work, make steps to improve and continually monitor your progress.

2. Pull your credit reports and dispute errors.

A 2013 Federal Trade Commission study found that 1 in 4 consumers identified errors on their credit reports that might affect their credit scores. The same study found that 5 percent had errors on one of their reports that could lead to them paying more for products such as auto loans and mortgages.

Don't let errors on your credit reports cause you to pay more than you should. Before looking for a mortgage, be sure to pull all three of your credit reports and dispute any errors that could affect your score, such an incorrect account or the wrong credit limit. The dispute process may not be instantaneous, but the time and effort you put into ensuring your reports accurately represent your credit history will be worth it if it saves you money on interest.

3. Pay off outstanding delinquent accounts.

Like other lenders, mortgage underwriters want to ensure you're a reliable borrower who will make payments on time, so having outstanding delinquent accounts on your credit report can drastically hurt your chance of being approved. Before you apply, consider paying off any delinquencies. Also try to lessen the impact late payments may have on your score by burying them with months or years of timely payments first.

4. Reduce your debt-to-income-ratio.

Your mortgage underwriter could use your debt-to-income ratio, or the percentage of your income that goes toward paying debts, to evaluate how much additional debt you can handle and how much of a credit risk you pose. According to the Consumer Financial Protection Bureau, studies have shown that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. If you're already using most of your income to pay off debt, lenders may not trust that you'll be able to make your mortgage payments on time and either decline your application or penalize you with high interest rates.

If you want to lower your debt-to-income ratio, you can either increase your income or lower your debt payments. Making more money may seem easier said than done, but there are multiple ways you can do so. Think you're doing great work? Consider asking for a raise. Have some extra time on your hands? See if you can make some money during your spare time. A little money could go a long way in lowering your debt-to-income ratio.

Also try to pay down your credit card balances. Not only can this help lower your debt-to-income ratio, but it could also improve your credit health.

5. Practice caution when applying for more credit.

Since you want your credit score to be as high as possible when the mortgage underwriter is making a decision, consider holding off on applying for more credit until after everything is finalized. Each credit application could result in a hard inquiry that could potentially lower your score, so it's important to question whether you really need the extra credit immediately or whether it can wait.

The Bottom Line

Remember, it could take a while to improve your credit. Huge score jumps don't usually happen overnight, so it's important to start working on your credit as soon as you start thinking of buying a home. Don't pay more interest than you have to. By educating yourself and putting some effort into making your credit score the best it can be, you could save yourself a lot of money.