Will Your Credit Rating Deter You From Getting a Mortgage?  Here's How It All Works

Most of us assume that if we’re paying bills on time and haven’t yet maxed out the credit cards, our credit record is spotless. But, there are many factors that can mar your credit rating and it is important to learn your credit status before visiting the bank.

One factor that is growing in prevalence is identity theft. Its effects can scar your credit rating for years. It always comes as a shock to learn that a thief has gotten hold of your social security number, run up all kinds of debt, and ruined your credit rating in the process, but, it’s better to find out before you need a new mortgage than while you’re trying to get one.

Another factor that can sink your status in the eyes of a potential lender is a bill from a doctor or hospital that you thought was paid by your insurance company but has been sent to an agency for collection. “Everyone goes through massive confusion about what the insurance company will pay and what the individual is responsible for paying,” says Jim Huffman, director of mortgage services at Leaders Bank in Oak Brook. “The average person is likely to have a collection account or two because of medical bills, and it’s one of the biggest culprits of deteriorated credit scores.”

Knowing the Score. To understand how a dispute over a $100 medical bill can cost you thousands of dollars when you apply for a mortgage loan, you should be aware of how the credit rating system works. Three major credit-reporting bureaus—Experian, Equifax and Trans Union—keep track of the credit accounts of millions of Americans. For each credit report they compile, they also issue a FICO score, which is a numeric value weighted by factors such as your payment history, the amount of the balances you have outstanding, and the amount of credit you have available. Collection items weigh heavily in the calculation.

When you apply for a credit card or a loan, the merchant or financial institution will want to know your FICO score. Because the credit bureaus have similar but not identical models of what constitutes a perfect credit risk, Leaders Bank gets an applicant’s score from all three bureaus, then bases its rate and approval on the middle score.

“Everyone starts with a perfect score of 860 points and you lose points for certain items that appear on your credit report,” Mr. Huffman explains. “We consider a score of 720 excellent and usually ask to see only a pay stub to show that the person is currently employed. At 680, we’ll need a little more information, such as two years of income tax returns.”

Doors begin to close as the credit score goes down. If a lender offers a loan program at a benchmark of 620, for example, at a score of 619 a person will probably pay a higher rate. Mr. Huffman says that there are sometimes ways to counsel around credit issues, but it’s always time consuming and, meanwhile, rates can change. One buyer seeking a jumbo mortgage wound up with a worse rate after re-applying only six weeks later, and the difference is costing an additional $2,800 a year.

What You Can Do. Mr. Huffman suggests getting a copy of your credit report and FICO score before applying for a loan. (You can get them online from the reporting bureaus for a small fee.) To show a better debt picture, it might be advisable to consolidate certain credit cards and retire some accounts. But consolidation can be tricky. Because you lose more points for an account that’s drawn to its credit limit, you’re better off with two accounts that are each only half drawn.

You definitely want to take care of any collection accounts, especially since they may make you ineligible for certain mortgage products. “If you can’t figure out whether a medical bill has been paid, call the doctor’s office and ask if they’ve submitted the claim to the insurance company,” Mr. Huffman advises. “Call the insurance company and ask if they got the submission. The worst thing anyone can do is to say, ‘It’ll work itself out.’ Because it doesn’t. And having your credit history deteriorate is absolutely more expensive than paying a few hundred dollars for a bill you may not owe.”

If you see accounts on your credit report that you know you haven’t opened, someone has probably stolen your identity. “Identity theft is devastating, and it’s one of the fastest growing crimes,” Mr. Huffman says. If you suspect it has happened to you, contact the credit bureaus immediately and have them put a fraud alert on your credit history report. To protect yourself, don’t carry your social security card in your wallet, and don’t put the number on your driver’s license. Destroy receipts and solicitation letters that have your credit card number on them. He believes a paper shredder would be a wise investment.

While identity theft and collection accounts resulting from unpaid medical bills aren’t the only factors that can affect your credit score, they are two factors that you can watch for and work to prevent. Evaluating your credit rating beforehand will help you prepare the next time you need a mortgage.