If you’re shopping for a home loan to purchase a house, you may notice different lenders advertising the best interest rates for their mortgagees. On top of that, you’ll start to see that different loan products have different rates. What you should understand before you apply for a mortgage is that not everyone qualifies for those low interest rates.
They are only given to buyers with the best credit scores, while other people are required to pay a higher interest rate. Before you decide on a mortgage or put in an offer on a home, it’s important to learn why credit scores impact your mortgage rate. Keep reading to find out what this difference means to you and how you can work to get the best rate possible. With such a large purchase and one of the biggest decisions you’ll ever make, you need to be informed about your options.
- 1 What is a Credit Score?
- 2 Why Mortgage Lenders Use Credit Scores
- 3 Types of Mortgages and Credit Score Requirements
- 4 How Mortgage Rates Impact Your Payments
- 5 How to Improve Your Credit Score for Your Mortgage
- 6 How to Prepare for a Mortgage with No Credit
What is a Credit Score?
First, you need to understand what a credit score is. A credit score is a number determined by credit reporting agencies that tells lenders how much of a risk you are for borrowing money. The number is determined by how much credit you have, how well you’ve paid your bills, and how you utilize your credit. Included in your credit score are all of your credit accounts, including current and past credit cards and any loans.
Auto loans, personal loans, and mortgages all influence your credit rating. Each type of account has a different weight on your credit score. Also factored in is how you pay those bills. The later you are in paying your credit accounts, the more it lowers your credit score. A late payment is reported after 30 days, with extra dings every 30 days of non-payment.
How much of your credit you use is also considered. If you max out your credit cards, you’ll lower your score more than if you only carry a low balance. Other factors, such as recent credit applications and credit account age are also included. These factors combine to create your credit score. When anything changes, your score also changes based on whether the information is positive or negative.
For instance, you may have a 720 credit score. But if you make a payment 30 days late, your score could drop to 610. A second late payment may put it to 580. On the other hand, if you pay off your credit cards on time for several months you may see a low score start to rise. The exact increases and decreases depend on a number of things, but you can get an idea of how quickly your credit can fluctuate.
Why Mortgage Lenders Use Credit Scores
There are a few different reasons why mortgage lenders review your credit score during the home loan application process. Here are some of the most common ones.
Approving Your Mortgage Application
Mortgage lenders rely heavily on credit scores as do other lenders to help them determine whether to accept or deny your application for a mortgage. A credit score is an indication of how big of a risk they are taking by loaning money to you. The lower your credit score, the higher the risk that you will default on a loan.
Almost all creditors use credit scores when reviewing applications today. Even landlords and insurance companies will sometimes look at credit history to find out if you have a reputation for paying your bills or falling behind on debt.
Determining Your Interest Rate
Not only do mortgage lenders use credit scores to determine if they will provide a loan, they use it to determine at what interest rate. Even if you qualify for a mortgage, you may not receive the best rate because of your credit score. Most home loan lenders reserve the best rates for those with excellent credit.
You’ll pay a higher interest rate if you have a lower credit score because you are a higher risk. The interest rate is an important aspect of a mortgage because it not only tells you how much you’ll pay each month for the loan, but it impacts how much of a loan you can get. A lender who approves your application for a mortgage sets a limit on the amount based on how much money you earn and your other debts.
A higher interest rate lowers the amount of money that may be loaned to you because it is based on your total monthly payment. A mortgage lender generally keeps your mortgage payment around 30% of your monthly income. This includes the interest and principal payment, plus real estate taxes and homeowners insurance.
If you have a higher credit score, you may also qualify to have a higher payment. For instance, a person with a 640 credit score may only be able to have a mortgage payment at 30% of their income. Someone with a score of 720 may be able to qualify for a loan payment at 38 percent. It all goes back to risk because someone with a higher mortgage payment will be at more of a risk to default. Someone with low credit increases that risk.
Types of Mortgages and Credit Score Requirements
The type of mortgage you are seeking will have specific credit score requirements. Some loan products are more flexible than others. For example, conventional loans usually have stricter requirements than government-backed loans. FHA, VA, and USDA mortgages are backed by the government if they default. They often carry lower requirements for credit scores because the lender has a guarantee that they’ll get their money back for foreclosures.
A USDA loan comes with a credit score requirement of 640, which is also the case with an FHA loan. However, people with credit scores below this cutoff may still qualify for these loans, but they will have additional paperwork and steps to be approved. For example, a person applying for a USDA loan with a credit score below 640 will need to get references from their landlord and write a letter of explanation for any negative information on their credit report.
Credit score requirements are uniform for these types of loans regardless of your lender. However, the lender may add additional requirements. For example, just because an FHA loan accepts people with a credit score below 640 doesn’t mean that all lenders will approve the application.
Requirements can also change. For example, it used to be rather common for people with credit scores at 580 or above to be approved for an FHA loan before the housing crisis. That changed after the recession, so that now it is very difficult for someone with a credit score that low to get a home loan.
Conventional loans must meet certain regulations, but those products are unique to each bank because they are not backed by the government. Instead, they must meet specific guidelines that the bank sets so that it can resell the loan and show financial stability based on its loan portfolio.
How Mortgage Rates Impact Your Payments
Many people look at interest rates on mortgages and think that it can’t make a big difference. After all, how big of a deal is it whether you get a loan with an interest rate of 3.45% versus one with a rate of 3.15%? You’re talking less than one point, so it may not seem important. However, you’re also talking about a loan of more than $100,000 or more, plus a timeline of 30 years.
This magnifies the impact of even a small change in interest rate, which can mean the difference of thousands of dollars for how much you’ll pay. For an immediate impact, it also changes your monthly payment, which limits the amount you can borrow or determines if the payment fits in your budget.
Mortgage Rate Case Study
Here is an example of the difference in a loan based on the interest rate:
Say you’re seeking a mortgage for $200,000 at an interest rate of 3.45% for 30 years. You’ll pay $893 per month in principal and interest with a total of $121,306 in interest paid. Now, move that rate up to 3.75% and your payment changes to $926 per month and a total of $133,443 paid. This is a difference of more than $30 per month, which isn’t likely to break your budget, but over $12,000 more paid over the life of the loan.
If that interest rate goes up to 4.00%, you’ll see an even bigger impact. Now, you’re paying $955 per month and $143,739 in interest for the life of the loan. Of course, if you borrow more, the impact is even more severe. Turn that $200,000 into $250,000 at the 4.00% interest rate and your payment is $1,194 with $179,674 in interest paid.
If you wonder how the different interest rates for the various loan products you’re considering will impact your monthly payments and total amount paid, do a search for an online mortgage calculator. This one exercise can help you decide which loan product to select or even to wait to improve your credit score before you buy a home.
How to Improve Your Credit Score for Your Mortgage
Improving your credit score could have a big impact on how much you have to pay each month for your mortgage, as well as the total amount you’ll pay over time. It also determines if you qualify for a mortgage and what type. Because it has such a big influence over your decision to buy a home, you should know that you can improve your score.
The first step in purchasing a home should be to obtain a copy of your credit report and your credit scores. This allows you to know where you stand. If your score isn’t where you want it to be to get the best rates, you should look at the negative information that may be keeping it down. Here are some steps you can take to improve your credit score:
- Make all your monthly payments on time
- Pay down any credit card balances
- Pay off collections accounts – while it won’t remove them from your report, it will look better to lenders
- Dispute any inaccuracies on your report
You can also talk to lenders about their loan products and what specific requirements they have. Some will say no late payments for the past year or all collections accounts paid off. Just make sure you get this information without having the lender run your credit because it can lower your credit score every time someone pulls your credit report.
How to Prepare for a Mortgage with No Credit
If you don’t have a lot of credit history, you may need to open a credit card to help you establish one. Lenders are often as wary of people with no credit history as those with bad credit. Just know it takes about six months before the account will be reported and have a positive impact.
It also takes about two years for negative information to have a reduced effect on your credit score. So, work to add positive information that is newer and wait for the old negative stuff to lose its impact before gearing up for your mortgage application. That way, you can get the best rates and terms possible.
Credit scores carry a lot of weight with lenders when you are searching for a mortgage. It pays to understand what they are, what factors impact your score, and how you can improve your current score. Then you can determine which type of home loan is best for you and how much of a loan you can afford.
Take the time to talk to financial professionals to help you understand how the biggest decision of your life will impact your budget. Think about the near terms as well as the future. Never take it lightly when you apply for a home loan, so do your research and make sure you can afford the house payment. Otherwise, it may be best to wait until you are more financially secure with a higher credit score for a more affordable loan.