Most of the biggest myths in the financial world revolve around the credit score and how it relates to your life. Almost anything you will read will tell you to maintain good credit so you can qualify for mortgages and car loans. The only problem is that building that credit involves going into debt and paying it off. There is a small subset of us who have actually researched this financial topic pretty heavily and who want to build solid wealth over time that understand this relationship. I will teach you to pay off your debt, build a solid emergency fund, and use your cash flow to purchase and grow solid assets over time with less risk. This means no car loans, no furniture loans, no student loans, and no credit cards. But this will lead you into a place that many people are perplexed about. If you pay off all of your consumer debt and do not use credit cards within 6 to 9 months your credit score will be “undefined”. Now most people will consider this moment one where they are in the best financial shape they have ever been in, but we have been taught to view the credit score as a measure of financial stability. So how can you be in the best shape yet have no credit score? It’s because the credit score really doesn’t measure financial stability. It really just measures how well you “play the game” the banks. To put it another way “The truth is that the best way to build a great credit score is not necessarily a great way to build wealth. There are plenty of people who are completely unprepared for retirement, living paycheck to paycheck with a negative net worth who have fantastic credit scores. A high credit score means that you tend to manage money in a way that makes you a good person to lend money to. That's very different from managing money in a way that will help you build wealth.” -DailyFinance
So since I do not use credit cards and am completely debt free I will be in a place with no credit score and I am quite happy about that. I view it as a sign that I am leaving “normal” behind. When I tell people this usually the first question that comes up is “well how are you going to buy a car?!” That one is fairly simple "…I’m just going to save up and buy it…” The next one is a little more complex, “How are you going to be able to get a mortgage without one?!?” This is not quite as quick of an answer. That is why I wanted to write this post about it.
How Mortgage Loans Work
Before I go into the specific details, I think it is important that we learn a little bit about how mortgage companies and mortgages work (If you are the impatient type that just wants the meat then you can skip to the next section without much disruption).
For many young professionals a mortgage is one of those things that you feel like you should know about, but when you really think about it you really don’t. At least that is how I was. The basics of a mortgage is very simple. It is where a bank will lend you money (combined with some of your own) to go purchase a home. This loan is called the “mortgage”. You will then pay this loan off over time with some interest so that the bank makes money. There are various terms to mortgages and various types. The mortgage that I recommend is a 15-year fixed rate mortgage. More on that later. A mortgage is what is called a “secured” loan. That is because if you fail to pay for the house and get foreclosed on, the bank will then repossess the house and can sell it to recoup its money it has tied up in it. Now banks typically don’t want to go this route because sometimes they don’t get all their money back. So it is very important that the banks correctly assess the risk of the borrower, which is yourself. To do this they undergo a process called underwriting.
Underwriting is where either a system or a person dives into your data and assesses your risk. This process is the meat of what a bank’s “competitive edge” is in the mortgage business. If you think about it what separates two major banks when it comes to mortgages? Maybe some market better than others. But more so it is their ability to correctly assess the risk of the borrower and assign the correct interest rate to make up for that risk. Therefore, bank’s take this process very seriously. Now humans have been shown to be pretty terrible at measuring risk in an objective manner. We are emotional creatures and emotions tend to lead to bad results when it comes to financial things. So what many banks have done is created an automated algorithm that uses specific information combined with statistical models to define the risk of each borrower and decide whether they are approved or not. This is where the credit score comes in. The credit score was designed for banks to be able to take that information and use it in their models. Unfortunately, like we stated above, if you don’t have much in the way of debt history then the system breaks down. So most people assume that in order for the bank to take the risk of loaning you money for a home that they have no gauge upon your risk then they will either deny you or charge you an ungodly interest rate. That logic isn’t necessarily wrong, but there is still one secret of the industry that most people don’t know about.
Before the advent of computers and the credit score it was up to people to review your documents and assess your risk. Luckily there are still some banks around that can do these loans like Churchill Mortgage. What this means is you can still get a loan without a credit score at the same interest rate as a loan with a credit score. That being said, there are some things you need to be aware of. First, in order to qualify for a home loan you must first BE ABLE TO AFFORD ONE! All too often I see people saying “I think I am going to buy a house” and are paying 2% down with an adjustable rate mortgage. This is just trouble waiting to happen.
Here are some things you need to do to qualify for a no credit score loan. I will quote some of this directly off Churchill’s website:
1. “Make sure you have 4 alternative credit trade lines, with one of them being a rent or lease payment. Contact the creditors and get a letter from each of them on their letterhead showing your name and account number, and stating your account has been ‘paid as agreed for the last 12 months.’ This is a good start, but further documentation could be required from the creditor.” So make sure you pay your rent on time. Another three alternative credit lines could be electric bill, cell phone bill, and car insurance. All three of those are things you are probably already paying anyways. Obviously the more and the longer, the better.
2. Apply for a 15 year fixed rate mortgage with a 20% down payment. If you don’t have a 20% down payment then the mortgage company will have to get insurance on the loan itself called PMI. “It is not uncommon for the loan to be approved by the investor then turned down by the mortgage insurance company. That means the deal is dead - end of story. We have found the loan that has the best chance for approval is one that is on a 15 year fixed rate and the borrower has 20% down. This eliminates the need for the mortgage insurance, and presents a lower risk to the loan servicer.”
3. Make sure your mortgage payment is no more than 25% of your take home pay with a solid work history. This will show the lender that you have more than enough fluff in your budget to make that mortgage payment even if hard times hit.
4. Have a fully funded emergency fund of 3 to 6 months of expenses before you apply for the mortgage. This will show the lender that even if you were to lose a job you have enough liquid savings to cover you through those hard times.
5. Lastly, “get preapproved long before you start looking for a home. You don't want to get your hopes up and get emotionally attached to the home of your dreams, only to wait 45 days and find out you cannot get approved.” Don’t wait until the last minute. Have your down payment and loan amount ready to go before you start looking. It will make sure you don’t make a rash decisions in the heat of the moment.
Of course there are always some downsides. The biggest downside with having to do manual underwriting is the time. It takes much longer to get approved for a no credit score loan than when you are doing automatic underwriting. “No credit score loans require an underwriter to scour every piece of documentation in the file from your paystubs and W2s to the 24 pages of the appraisal to make sure the risks have all been identified. That takes time - about 3 times as long as a normal borrower file. Don't look for quick answers, because the quick answer is easy - no. We want to give that underwriter time to be familiar with all the aspects of your loan file so they can give the approval with confidence. This may even require additional documentation that doesn't seem to make sense to most of us. But let's remember the goal; give the underwriter what they need to feel comfortable with the risks on the loan to issue an approval. From the time the underwriter receives the file, I would give them at least 2 weeks to underwrite it. That probably takes a normal 30 day loan process up to about 45 days. Therefore, keep this in mind when writing a contract closing date.”
Another downside is that sometimes it is hard to find a bank that is still willing to do this. Churchill is an option and other smaller banks will probably do so as well.
There are many benefits to going about your finances this way. First and foremost, it means you can escape the “normal” financial thought and focus on actually building wealth over time. One of my biggest problems with credit cards is that it takes people’s attention away from the fundamentals. Getting out of debt, spending less than you make, and finding good investments over time. Instead people are so worried about how to maximize credit card rewards that they forget about their retirement until they are in the late 30’s to early 40’s. Knowing that you don’t need a credit score to buy a home is a very freeing feeling. It means you can focus on managing your cash flow correctly and keeping everything in balance.
Next, having a solid down payment (20%) and a shorter loan life (15 year vs. 30) means you will be able to pay off your home in AT LEAST half the time of a normal loan and you will pay dramatically less interest. You can save hundreds of thousands of dollars just by making this one decision! The payments will be slightly higher than if you have a 30 year loan. But as long as you use the guideline of not having your mortgage payment more than 25% of your take home pay then you will be fine.
What Does This Mean
This means that in the end, the myth that you can't get a mortgage without a credit score is simply that - a myth. you can still get a mortgage without a credit score. It may take a little longer and you will have to make sure you are buying a house that you can afford, but you should have been doing that anyways. Remember, the credit score says nothing about your wealth or your financial standing. A high credit score only means you know how to payments.