Pay the right things off - and take care not to pay off accounts you need to show your responsible use of credit. A few things that most lenders will demand you settle, bring current or pay off entirely before you can buy a home:
- accounts in collections
- state and federal tax liens
- past home loans or lines of credit in default that were not extinguished through foreclosure or short sale (e.g., second loans, home equity lines of credit, etc.)
- defaulted federal student loans (for FHA loan applicants).
If you do have to negotiate with any such creditors for settlements or repayment plans, consider including the way they report the account as one of the negotiables in your settlement deal. Consult with your mortgage professional about how you should ask the creditor to report the resolution as part of the settlement - you might not get it, but it certainly doesn’t hurt to ask.
Your mortgage pro can also help you understand how you should sequence and prioritize the various items on this little laundry list. For example, some lenders might allow you to simply extinguish a tax lien at closing, while most FHA loans won’t allow for a credit pre-approval while you have a defaulted federal student loan on your report.
But do exercise some caution when you start paying off debt in preparation for home buying. Some house hunters take the opportunity to pay all their debt off and close out old, unused accounts, thinking it will document their readiness for the financial responsibilities of homeownership. Not so: credit scores are optimized when they show that you (a) have credit available to you, and (b) are responsible in how you use it. The ideal for the FICO score calculations is to be using roughly 30 percent of the credit available to you on your accounts. So don’t pay them entirely off, and whatever you do, don’t close accounts that are open and/or current.
That said, don’t go out charging up a storm trying to bring zero balance accounts up to 30 percent credit limit usage. A flurry of new charges can upset your debt-to-income ratio and be seen by the FICO calculating robots as a sign of potential financial distress