Your credit determines your ability to get a mortgage more than any other qualifying factors. If you have bad credit, many lenders will turn you down. If you have no credit, you could also get turned down. So which is worse – no credit or bad credit?
The truth of the matter is that they are both bad, but the worse of the two is to have no credit. If you have no credit, a lender has nothing to help them determine whether or not you are a good credit risk. With bad credit, at least the lender can determine where you went wrong and ask the right questions to determine if it was a one-time occurrence or if you are a repeat offender with bad credit decisions.
Why Bad Credit is Better than No Credit
Bad credit, at the very least, shows that you are capable of having credit lines. If your score is low, the lender can go through each credit line to determine why the score is so low. There are a variety of reasons this could be the case, including:
- Using too much of your available credit at one time
- Having late payments
- Having collections
- Having too many open accounts
- Having accounts that are fairly new and do not provide enough of a history
Each of these reasons gives the lender a different perspective on the level of risk you create. For example, if you overextend yourself, taking out all of your available credit at once and then only make the minimum payments toward each debt, you pose a high risk to the lender. It shows that you use all of your credit and do not have the resources to pay it off, which equates to irresponsibility. Every lender will look at this scenario differently and the decision will change based on whether the payments that you make are on time or late.
Another scenario that could have underwriters going either way is if you have accounts that are new and you just do not have a long history. An underwriter can get the gist of what is going on and figure out if your score is low strictly because your credit is too new, but that does not make you a good risk. This is a completely different scenario than the above scenario where credit was too extended – the credit is just too new. This could pose to be as much of a risk because the lender does not know your propensity to pay your debts on time.
Bad Credit Does not Always get Turned Down
Contrary to popular belief, bad credit is not always turned down. Now, it might change the interest rate that you are provided, depending on how bad your credit really is, but it might not render you without a mortgage as having no credit could do. At least with bad credit, the lender knows the type of risk they are taking and can price the mortgage product accordingly.
Typically, people with bad credit scores end up paying a higher interest and/or more fees, such as origination fees on the loan. This is the lender’s way of making up for the risk – they make their money up front, this way if you were to default in the future, the lender still made some money.
In this sense, bad credit is not necessarily the worst thing that could happen on a mortgage application. If you were to place a person with no credit and a person with bad credit side by side, chances are the person with bad credit would get the loan over the person with no credit – the rate would just likely be higher.
How to Start From Scratch
If you are in the category of people that have no credit, now is the time to start building it because it could take quite a while to make it happen. You do not open a credit card one day and magically have a credit score the next day; it takes time. The earlier that you apply for credit and use it, the faster your credit will build up.
Typically, people start with department store credit cards or credit cards offered by the bank they have checking or savings accounts at currently. Once you get approved for a credit card, use it regularly. There is a specific way to use it, though. You should not run out and max out the credit line – you need to use the available credit sparingly.
Credit bureaus like to see the amount of credit that you use compared to the available credit maxed at 30%. So let’s say for example that you have a credit limit of $1,000. You can charge up to $300 at a time in order to keep your utilization rate low. Of course, if you need to charge something large, you can do so, just make sure to pay it off right away and never charge so much that your card is maxed out.
If you have bad credit and want to fix it, you are essentially starting from scratch as well. In this case, you have to do damage control. Start by assessing the reason for your bad credit. Are you late on your payments? Do you have too much credit outstanding? Are there collections? These are a few of the things to assess, and then you can react.
The best thing to do is bring all accounts current. This should be done before you try to pay anything off – current payments will help to bring your score up slightly. Once everything is current, you can figure out the best plan of attack for your situation. If you have a large amount of outstanding credit that brings your utilization rate up, pay some of those balances down.
If you just have a large number of cards open and with balances, start paying one down and eventually, off at a time. You should never close old accounts, even if they have a bad history. Once you bring them current or pay them off, leave them alone. If you close them, you lower the average age of your available credit, which can lower your credit score in the long run.
The bottom line is that it is better to have bad credit rather than no credit. Bad credit can always be fixed; even if it does take some time. You can work at it a little bit at a time in order to get your accounts current and eventually get accounts paid off. On the other hand, you really cannot fix no credit.
Sure, you could apply for a credit card or small loan, but you will not get a large amount of credit extended to you because of your lack of credit, which could lead to issues down the road. If you have the choice between opening new credit and paying cash – open the new credit and let your credit history start building in order to set yourself up for success when you apply for a mortgage in the future.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.