The relationship between credit cards and buying a house

The Fed has finally begun lowering interest rates, which could be stirring up dreams of finally shopping for a new home. But the last several years of high rates may have taken a toll on your credit card balances, debt-to-income ratios and even your credit score. 

If you’re interested in buying a house, it’s crucial to consider your entire financial situation, including your credit card strategy. Too much debt and too many credit inquiries can hold you back, whereas a good credit card rewards strategy can put money back into your pocket.

Let’s start with the financing component. Houses aren’t cheap, after all. Ideally, mortgage lenders want applicants to put no more than 28 percent of their gross monthly income toward housing payments (principal, interest, property taxes, homeowners insurance and homeowners association fees). Adding in other debt payments (credit cards, auto loans, student loans, etc.), the recommended debt-to-income ratio is no higher than 36 percent. Lenders have some flexibility to go a bit higher, but if your total housing and debt payments gobble up more than half of your gross monthly income, your odds of approval are quite low.

Credit card debt

The average American has a credit card balance of $6,329, according to TransUnion. It’s important to note that credit reports simply look at how much you owe on your credit cards at a moment in time (typically the statement date). They don’t distinguish between true debt — that is, balances carried over time and assessed interest — and credit bills that cardholders pay off before interest hits.

According to Bankrate’s Credit Card Debt Survey, half of cardholders typically pay in full each month. That’s a great practice to avoid interest, but it’s not necessarily enough to optimize your credit score. You might still have a high credit utilization ratio (credit you’re using divided by credit available to you). Especially if you’re in the market for a large loan, such as a mortgage, you want this ratio to be as low as possible. Making extra mid-month payments and/or requesting higher credit limits are good strategies for reducing your credit utilization ratio, which is part of the “how much you owe” factor that FICO uses to build your credit score.

Credit scores

Speaking of your credit score, the FICO formula is 35 percent payment history, 30 percent how much you owe, 15 percent length of credit history, 10 percent credit mix and 10 percent recent credit inquiries. This last category is especially important when it comes to credit cards and mortgage seekers. It’s generally advised not to rack up more than five hard inquiries within a two-year span (hard inquiries tend to represent formal applications for credit, while soft inquiries don’t affect your credit score and refer to things like self credit checks, background checks and marketing campaigns).

You should be especially careful not to accumulate any additional hard inquiries during the mortgage application process. These generally cause your credit score to dip five to 10 points in the short term. That doesn’t sound like a big deal, but there’s also a slight negative effect from lowering the average age of your accounts, and even a small drop in your credit score can raise your borrowing costs by tens of thousands of dollars over the life of a large 30-year loan. Plus, applying for too much credit in a short span can make you look like a risky, desperate borrower.

Even if you got prequalified or preapproved, don’t mess anything up before closing. The lender will run another credit check and review all relevant documentation just before you close on the purchase. I’ve heard horror stories about people who signed up for a bunch of credit cards to try to earn rewards on new furniture and other home improvements only to jeopardize their chances of getting the lowest possible mortgage rate. Don’t sign up for any new credit cards or rack up any big expenses until after closing.

Credit card rewards

Speaking of rewards, as long as you wait until after closing, a home purchase can be a great time to sign up for a new credit card. That’s because the best introductory bonuses typically require you to spend a few thousand dollars within your first few months with the card. An intelligent strategy is to align a new card sign-up with a natural spending spike. And a home purchase certainly qualifies, since you’ll probably be paying for moving expenses, legal fees, new furniture, paint, appliances… you name it.

The bottom line

Buying a house is likely the most expensive purchase you’ll ever make. You’ll want to put your best foot forward from a credit scoring perspective, which means using credit cards and other financial products responsibly. As long as you pay on time and in full, credit cards can help you build credit without paying interest. Credit card rewards are a meaningful benefit, too — just make sure you wait until after the mortgage closing to sign up for any new cards.

Have a question about credit cards? E-mail me at ted.rossman@bankrate.com and I’d be happy to help.