Acquiring a mortgage is a significant financial milestone for many Australian home buyers. The steps taken leading up to the application process can have far-reaching consequences. Whether you are a first-time buyer or a veteran in real estate pulling together cash for an investment, Aussies often grapple with whether to close credit cards before applying for a mortgage. This complex decision requires careful consideration, as it involves a delicate balance between managing credit history, credit card debt levels, and the impact on one's mortgage eligibility.
Credit Scores in Mortgage Applications
Credit scores are a critical determinant that significantly influences a borrower's eligibility and the terms they are offered. Understanding credit scores is paramount for individuals seeking to secure a mortgage, as it serves as a numerical reflection of their creditworthiness.
What is a Credit Score?
In Australia, credit scores typically range from 0 to 1,000 or 1 to 1,200, depending on the credit reporting agency. One of the primary roles of credit scores and affordability assessments in mortgage applications is to provide lenders with a quick and standardised measure of an applicant's creditworthiness. Your creditworthiness or the likelihood you will make the loan repayments on time plays an important part in the mortgage application. Lenders perceive you as more risky when you have a lower credit score. Lenders rely on these lending criteria to gauge the level of risk associated with lending to a particular individual.
Credit scores serve as a key factor in determining whether a borrower qualifies for a mortgage. Lenders often establish minimum credit score requirements, and individuals with higher scores are generally viewed as lower-risk borrowers, increasing their likelihood of mortgage approval.
What's the average credit score in Australia?
The average credit score among Australians is 855 according to credit reporting company Equifax (Equifax Credit Report, November 2023). That means Australians have a ‘very good’ credit score on average. Women (868) have a higher average credit score than men (850), while the average credit score is higher for older Australians. This means you cannot always rely on the 'good' 'average' ratings in credit score systems to give you a true indication of how your credit score will be reviewed by a lender.
How Does Your Credit Card Affect Your Home Loan Application?
Credit scores and mortgage application
Credit cards contribute to building your credit score - it is a known fact; however, there are certain aspects of your credit card usage that may pose challenges when you apply for a mortgage. Even if you have a clean credit history and no bad credit, you need to be aware that merely possessing a credit card or applying for new credit cards can significantly influence your borrowing capacity. This is because many credit bureaus evaluate your credit rating based on your credit card limit rather than your current balance.
Credit history
When seeking a new home loan, the primary question on a lender's mind is whether you have the ability to repay it. In order to address this question and instil confidence in your financial habits, lenders thoroughly examine factors such as your income, expenditures, debts, dependents, employment history, and obviously, your past borrowing and repayment behaviour, i.e., your credit history.
Credit limit
And there’s more - regardless of whether you utilise your credit card or consistently make monthly repayments, it will still influence the borrowing limit available to you. This is because what matters is your credit limit and the way you use it more than the outstanding debt or credit utilisation.
Nevertheless, a low credit score is not necessarily a lending death sentence, as the rejection of your home loan is not inevitable. While some banks may consider lending to individuals with a less-than-ideal credit score, it's probable that they will impose a higher interest rate.
If your credit is lower than average, before applying for any kind of loan product, it is a good idea to take steps to repair your credit.
Credit utilisation ratio
Responsible credit card management, such as making timely payments and maintaining a low credit utilisation ratio, can positively impact your credit score and, consequently, your mortgage approval chances.
Debt-to-income ratio
Your debt-to-income ratio is assessed by comparing your monthly debt payments to your income. Credit card balances contribute to this ratio, and high balances may affect your ability to qualify for a larger loan amount. Responsible credit card use, coupled with a lower debt-to-income ratio, can strengthen your home loan application.
Interest rate
The credit score of an applicant plays a pivotal role in determining the interest rate assigned to their mortgage. Borrowers with good credit scores are typically rewarded with lower interest rates with a fixed rate, translating to lower overall borrowing costs. Conversely, lower credit scores may result in high-interest rates to offset perceived lending risks.
LVR and deposits
Beyond interest rates, credit scores can influence other loan terms, such as the loan-to-value ratio and the size of the down payment required. Individuals with higher credit scores may have access to more favourable loan terms, including lower down payment requirements.
Credit scores also play a role in the types of mortgage products available to borrowers. Individuals with higher credit scores may qualify for a broader range of mortgage options, including more competitive and flexible products.
Late payments and defaults
Any history of late payments or defaults on your credit card can have detrimental effects on your credit score. Lenders view such instances as red flags, potentially leading to higher interest rates or even rejection of your home loan application. Consistent, on-time payments on your credit card are essential to demonstrate financial responsibility.
Having multiple credit cards
Possessing multiple credit cards can be seen as an indicator that you are exceeding your financial means. The greater the number of cards you possess, the lender will infer a higher monthly credit card payment obligation on your part.
Should You Close Your Credit Cards Before Applying for a Mortgage Loan?
The decision to close credit cards before applying for a home loan is a nuanced one and requires careful consideration of various factors.
- Affects the credit score
Closing a credit card can affect your credit score, as it may reduce the total credit available to you. Your credit utilisation ratio, which is the ratio of your credit card balances to credit limits, plays a significant role in your credit score. Closing a card may increase this ratio, potentially impacting your creditworthiness.
- Shortens the credit history
Closing older credit card accounts can shorten your credit history, potentially having a negative impact. A longer credit history is generally viewed favourably by lenders.
- Impacts the credit card limit
If you decide to close your credit card account, you reduce your available credit, potentially leading to an increase in your credit utilisation ratio. Consequently, this may have an adverse impact on your credit score. Lenders view borrowers with elevated credit utilisation ratios as potential risks, as it indicates a significant portion of their available credit is being utilised.
What Strategies Can You Employ With Your Credit Card to Enhance the Likelihood of Securing Pre-approval for a Mortgage?
Be a responsible credit card holder
Effectively utilising your credit card can indeed enhance your credit score, provided it is done judiciously. When you make purchases with your card and promptly settle the balance, it establishes a positive borrowing and repayment pattern, which potential lenders can assess.
Lower your credit limit
Another strategic move is to approach your bank and request a reduction in your credit limit. Aim to minimise your limit as much as possible. This dual-purpose action not only heightens your chances of securing approval for a home loan or car loan but also grants you better control over your credit card usage.
Use your credit card to improve your credit score
Demonstrating to your banks your adeptness in managing debt and handling your financial situation is crucial. Seeking the advice of a mortgage broker can be beneficial in exploring your options. These professionals may assist you in identifying lenders with more lenient policies regarding credit card utilisation. Moreover, brokers can provide guidance on the steps necessary to ensure that your credit card activity does not significantly impede your borrowing capacity.
You can utilise online calculators to make your own calculations, or alternatively, you can seek assistance from mortgage brokers to assess your borrowing power, particularly if you have a substantial outstanding balance on your credit cards.
