Understanding Your Credit Score
As noted above, your credit score is, without a doubt, the most important factor that lenders will examine when you apply for a mortgage. The higher your credit score, the higher your chances of qualifying for mortgages at favorable terms. So, what exactly is a credit score? A credit score is a number that represents your creditworthiness. In short, it tells potential lenders your likelihood to pay back a loan, subject to your credit history.
Credit scores range from 300 to 850. Most are within 600 and 750. A credit score of 700 or higher is considered good while a credit score of 500 or lower is considered poor. People with a high credit score are considered financially responsible when it comes to credit management. On the other hand, those with a lower credit score are considered as risky borrowers, due to their irresponsible financial management.
As much as exact scoring models for credit scores vary from lender to lender, most use the FICO Score as the reference point. To come up with your credit score, FICO evaluates your payment history, amount of debts that you owe, types of credit, new credit lines, and length of credit history. Your payment history and amounts owed account for the largest share of your credit score at 35% and 30% respectively.
You can request a free copy of your credit report from the credit reporting agencies such as TransUnion, Experian, and Equifax. Car loan companies and credit card companies also offer credit scores on their platforms. You just need to log into your account and you can check the report online.
How Credit Score Affects Mortgage Rates
Your credit score can affect various aspects of a mortgage. Besides determining whether you get approved for a mortgage or not, your credit score and credit rating will also affect the type of mortgage that you can secure, the amount of money you can borrow as well as the interest rates you will pay for the mortgage. And that's why it's important to check and understand your credit score and credit rating in the months leading to your mortgage application.
If you have a bad credit score, you will want to start working on ways of improving it before you apply for a mortgage. On the other hand, if you have a decent credit score, you will want to maintain it as high as possible. Let's examine how your credit score affects your ability to buy a house in the U.S.
- Mortgage Rates: Mortgage lending, just like other types of lending, is usually based on risk-based pricing. This essentially means that most lenders will determine your mortgage interest rates based on your estimated risks. The higher the risks, the higher the interest rates. If you have a low credit score, then you will be deemed as a risky borrower by the lenders. As a result, you will acquire the mortgage at higher interest rates, compared to someone with a high credit score. For instance, if you have a credit score of 625, you could be paying a monthly payment that is higher by approximately $100 per month. And if the mortgage is spread out over 30 years, you will end up paying approximately $36,000 more over the life of the loan, compared to the person with a credit score of 750. As you can see, it's clear that your credit score has a significant impact on the mortgage rate.
- Loan-to-value Ratio: Apart from the mortgage rates, your credit score can also determine the loan-to-value ratio or LTV. In simple terms, the loan-to-value ratio is the amount of a home's appraised value, which is not covered by your down payment. To get a property's LTV, you should take the amount owed on the loan, divide it by the appraised value of the property, and then multiply the figure by 100. So, how does the LTV ratio affect your eligibility for a mortgage? Borrowers with a poor credit score usually have a high LTV ratio, meaning they are considered as risky borrowers. As a result, their mortgages will come with higher interest rates, compared to those with a low LTV ratio. Furthermore, if you are purchasing a home using conventional loans, there is a high chance that you will be required to purchase private mortgage insurance or PMI, designed to cover the lender against loss, in case you fail to repay your mortgage. Private mortgage insurance usually costs an average of 0.5% to 1% of the loan amount per year. And you will continue paying it until your LTV ratio drops to 78% or below. Hence, if your mortgage costs $250,000, you will pay an extra $100 to 200 every month until you lower your LTV ratio to 78%.
- Eligibility for Loan Programs: If you have an extremely low credit score, some lenders may completely exclude you from certain loan programs. For instance, you cannot qualify for Freddie Mac and Fannie Mae mortgage loans if your credit score is lower than 620. And in worst-case scenarios, a low credit score can make you completely ineligible both for conventional loans and non-conforming loans.
- Leniency in Underwriting: Apart from your credit history, lenders also check your cash reserves, down payment, as well as income during the mortgage approval process. If you have a decent score, lenders can be lenient in areas such as down payment or income where you may be weak. On the other hand, if you have a poor credit score or a bad credit history, lenders will strictly adhere to the published requirements in all the areas. And this means you may fail to get the mortgage. For example, if you have a credit score of 750 and above but your income level is not where it's supposed to be for the loan or your employment history is weak, the lender may still approve the mortgage. Conversely, if your credit score is 650 or below and you are weak in the other areas, you will be deemed as a risky borrower and you will not qualify for the loan. In short, if you have a higher credit score, you will enjoy more flexibility during the approval process, compared to a borrower whose score is poor.
As you can see, your credit score affects various aspects of a mortgage. It affects the interest rates, the amount you can borrow, the amount you will repay as well as your eligibility for various loan programs. Therefore, you need to do your best to improve your credit history and credit score before applying for a mortgage. In fact, a difference of 50 to 100 points can make a significant difference when it comes to eligibility and terms of a mortgage.
Minimum Credit Score to Get Mortgage
So, what credit score do you need to buy a house in the U.S? As noted above, lenders use your credit score to determine your creditworthiness. Therefore, if you have a high credit score, you will definitely enjoy more mortgage choices as well as lower interest rates, compared to someone with a low credit score. Having said that, here is a look at how your credit score affects your ability to purchase a house.
300 to 499
If you are in this range, then your mortgage options are extremely limited. In fact, it's highly likely that no lender will give you a mortgage if your credit score is within this range. The only option that you may have is to talk to a family or friend, purchase the home on your behalf, and add your name to the title. After that, you will be refinancing the loan under their names.
500 to 579
If your credit score lies within 500 to 579, then the most viable option for a mortgage would be the Federal Housing Administration (FHA). And in case you qualify for this mortgage, you will be required to make a down payment of approximately 10% of the property's appraised value.
580 to 619
Borrowers within this range qualify for FHA loans at a lower interest range, compared to those in the 500s. If your credit score is in this range, you will qualify for FHA loans with a down payment of as low as 3.5%. At this level, you will also qualify for a mortgage if it's guaranteed by the Department of Veteran Affairs.
620 to 699
If you are a potential home buyer with a credit score of 620 or above, then you will enjoy more mortgage options. For instance, veterans, those in active duty in the military as well as their spouses qualify for government-backed loans and conventional loans. Furthermore, you will enjoy more-favorable interest rates, and you don't even have to make a down payment. United States Department of Agriculture (USDA) loans are also available for people who own rural properties with a minimum credit score of 640.
700 and above
As you may have expected, potential home buyers with a credit score of 700 and above qualify for better interest rates compared to those in the lower levels. At this level, you will also qualify for high-value homes. If your credit score is 740 or higher, you will enjoy the most favorable interest rates on the market, especially on non-jumbo conventional loans. Furthermore, you will also get a break when it comes to private mortgage insurance of PMI if you are within this range.
Tips for Improving Your Credit Score
If your credit score is preventing you from accessing the best deals on mortgage, it's highly advisable to postpone homeownership and start working on improving it, instead of settling for unfavorable mortgage terms. So, how can you boost your credit score?
First, make sure you evaluate your credit report before you apply for a mortgage and check for errors and inaccuracies. In case you come across missing or inaccurate information, you should file a dispute immediately with the creditor and the credit reporting agency.
Second, ensure you pay all your bills on time. Payment history accounts for approximately 35% of your credit score. As much as delayed or late payments can stay on your record for several years, their effect on your credit score reduces over time, especially if you make subsequent payments on time.
Third, avoid taking out large loans or opening new credit lines in the months leading to your mortgage application. According to FICO (Fair Isaac Corporation), opening too many new credit accounts can lower your score slightly. Also, you shouldn't close older credit lines after you've paid them off, since they may lower your credit score.
Fourth, ensure you keep your credit balances low. According to financial experts, you should keep your credit card balance to below 30% of your credit limit. Much lower is highly recommended.
It's important to note that your credit score will not improve overnight. However, taking these steps will significantly improve it. And with time, you will attain a decent credit score range, which will give you access to favorable mortgage rates and terms. After that, you can now start thinking about buying your dream home.