Credit can be a complicated topic but it’s one that every real estate investor needs to have some familiarity with. It will affect what loans you can qualify for and how much you’ll pay for those loans. Whether you’re a real estate investor or house hacker your credit will determine what properties you can invest in and whether you’ll be able to produce cashflow.
Here, I’ll break down what credit is, why credit scores are so important, who tracks these scores, and how they’re determined. With this knowledge, you’ll be able to build a strong credit score that can help you reach your real estate investing goals.
What is a Credit Score?
When people talk about their credit, they’re probably talking about their credit score. Your score is a number that lenders can use to gauge how trustworthy a borrower you are.
Scores can range from 300 to 850. Higher scores are better than lower scores.
It’s important to know that your score isn’t the be-all, end-all when it comes to applying for loans. Banks care about other things, like the amount of money that you make and the purpose of the loan. Even if your credit is perfect, you won’t be able to borrow $1 million if you only make $20,000 a year. However, a poor score can make it hard to get your foot in the door with a lender, making it difficult to qualify for a loan regardless of other factors.
What Determines Your Credit Score?
The first step toward understanding your score is knowing what affects your credit. There aren’t credit scoring agents who assign scores to people using their intuition or sixth sense. There’s a secret formula that is used to calculate your score based on several factors.
While the exact formula isn’t publicly known, these are the five major factors that determine your score, in order from most important to least important.
Your payment history is a massive part of your credit score, making up more than a third of the calculation.
It’s easy to understand why. Lenders want to make sure that you’ll pay back any money that you borrow, so they look at whether you’ve paid back loans in the past. Every payment that you make before the due date is a mark in your favor. Every missed or late payment will reduce your score.
Unfortunately, lenders and the credit scoring formula are harsh when it comes to late or missed payments. In the worst cases, one black mark in this part of your credit report can drop your score by 100 points.
Late and missed payments will remain on your credit report for seven years from the time that the payment was reported. As time goes by, the impact on your score will decrease until the black mark disappears from your report.
Your credit utilization is another major factor in determining your credit score, making up roughly a quarter of your score.
When you get a credit card, the lender offering the card will give you a credit limit. This is the most money that you can spend with the card without paying down the balance. The close you get to the limits on your cards, the lower your score will be. You should aim to use at most 30% of your credit limits across all of your credit cards and loan accounts.
Put yourself in the lender’s shoes for a moment. If someone offered to lend your friend Joan $1,000 and she immediately spent all that money, then came to you to and asked to borrow more, you’d be rightly concerned. Maybe she’s in dire financial straits and has no way to pay the money back. If she only used some of the money that the other person lent her, you might be less worried about giving her a small loan. That’s why your credit utilization is an essential part of your score.
Length of Credit History
Lending money is an uncertain thing. Lenders never know for sure whether they’ll get their money back, but they like to do their best to make accurate guesses as to who will repay their loans.
The longer your credit history is, the more information lenders have about your habits when it comes to borrowing money. That makes it easier for them to guess whether you’ll make your monthly payments. It also shows that you have more experience with borrowing money than someone who has a short history.
The longer your history is, the better your score will be.
Every time you apply for a loan or a credit card, a note is made on your credit report and your score can drops by a few points. Over time, the impact on your score decreases, until the note is erased from your report two years later. To keep your score high, only apply for new loans or credit cards when you need them.
Another thing that lenders look at is the average age of your accounts. Lenders like to see customers who form long-term borrowing relationships. Every time you apply for a new loan, the average age of your accounts is reduced, which decreases your score slightly.
The more experience that you have with borrowing money, the better you’ll be at paying back any money that you borrow. Lenders like to see that experience and that you have experience with different types of loans, such as credit cards, personal loans, and of course, mortgages. The more different types of loans you’ve had, the better it is for your score.
What are the Important Credit Score Ranges to Know?
Now that we’ve covered the different things that affect your score, you should know about the critical numbers and credit score ranges that lenders care about.
Any score between 720 and 850 is considered excellent. Most lenders have their top lending tier starting at 740+. As a real estate investor, this is the range you want to be in, as it will give you the best chance of qualifying for good mortgages and the best financing.
Scores between 690 and 720 are considered good. You’ll have a good shot of qualifying for loans if your score is in this range.
If you have a score between 630 and 690, your score is considered fair. You can still qualify for some loans, but you’ll have to pay more for the privilege.
If your score is below 630, you have a poor score. It can be hard to qualify for loans with a score this low and you’ll have a hard time getting mortgages that will allow you to effectively invest in real estate. Your best bet would be to try house hacking.
Who Tracks Your Credit?
Credit scores are complicated. Lenders don’t have the time to track scores for every person in the country, so they rely on other companies, called credit bureaus, to track it for them.
The three major credit bureaus are Experian, Equifax, and TransUnion. Each company tracks your credit history separately and produces its own credit score for you. In theory, each will have the same information and provide a similar score, but sometimes, mistakes can be made. That’s why it’s important for you to track your credit score and correct any errors as they appear.
When you apply for a loan, lenders will request a copy of your report from one or more of these credit bureaus. They’ll then use that information to make a lending decision.
Why is Credit Important?
If you do an internet search for credit, you’ll find a lot of reasons why it is important, but it’s particularly important for people who want to invest in real estate.
For one, it can be hard to qualify for a loan to buy real estate if you don’t have good credit. That can stop you from getting your investing plan off the ground. Perhaps more importantly, once you’re able to qualify for loans, your credit can make the difference between profiting from an investment and losing money.
Think about this example. You want to buy a property and need to borrow $250,000 to do so. Your credit is good, but not excellent, so you qualify for a 30-year mortgage with a 4.5% interest rate. Your monthly payment will be $1,267.
If you had excellent credit, you might be able to get a mortgage with an interest rate of 4%. The monthly payment for that loan will be $1,194, a difference of $73. If you rent the property out and hope to produce cash flow, you’ll put an extra $876 in your pocket every year, all thanks to your excellent credit.
From determining the loans that you qualify for to impacting the amount of cash flow your properties produce, understanding credit and how you can best improve your score can give you a leg up when investing in real estate. Learn how your credit affects real estate investing: https://fibyrei.com/how-your-credit-affects-real-estate-investing/