Wow. You’ve come to the point in life where you’re considering buying a home! Congrats—this is super exciting.
The process can seem overwhelming, but if you take the time to understand the pieces involved, everything will be okay. In brief, throughout the home-hunting process, you most likely don’t have the cash to pay everything in one fell swoop. Consequently, you’ll need to borrow some money via a mortgage.
Since a mortgage is a type of loan, all the typical loan terms arise. This is where your credit score plays a significant role.
Your credit score determines the amount of money you can borrow, your interest repayment rate, and your loan term. An excellent credit score will give you the best options available, whereas a poor one could make things difficult. In fact, a poor score could make it impossible to be approved for a mortgage.
Consequently, lenders need to look through your entire credit history to make sound judgments on your capability to repay. Some of the other documents you’ll need include your tax returns, W2, credit reports, and photo identification.
This article will overview the importance of your credit score throughout the mortgage process.
Why Do Mortgage Lenders Need My Credit Score?
Your credit score is a number lenders use to determine risk.
When lenders give you some money to borrow, they risk you defaulting on the loan. Defaults are when the borrower fails to repay their debt. Defaults damage the borrower’s credit score and cause the lender to lose a lot of money. A lose-lose situation.
In the case of buying homes, the lender insures against default through the home you’re purchasing. If you default on your mortgage, then the lender can take your home.
For example, if you have a perfect credit score of 850, then lenders will view you as extremely low risk. Thus, they’re likely to give you loans with the lowest possible interest rates because they feel comfortable letting you borrow money.
However, if you have the worst possible credit score of 300, then lenders will be very scared to lend you money. A credit score that low suggests that, in the past, you might have:
- Defaulted on loans
- Failed to pay your credit card bill on time multiple times
- Declared bankruptcy
- Fallen victim to identify theft
The list goes on, but lenders wouldn’t be likely to give you a loan in the first place since they’d be so scared to give you money.
The point of emphasis is that your credit score and credit history gives lenders an insight into your risk of default.
What Type Of Credit Scores Do Home Loan Lenders Look At?
There are several types of “credit scores.”
The three credit bureaus, Equifax, Experian, and Transunion, calculate credit scores based on the FICO and VantageScore models. The FICO score is the most commonly used credit score and is likely the one your lender is evaluating. The VantageScore is newer and is gaining prominence, but isn’t used as often as the FICO score.
It’s worth noting that some lenders may have their own custom “credit score” models. A FICO score of 750 might not necessarily translate into the same credit score within these custom models.
Does My Credit Score Matter THAT Much?
Yes. Simply put, increasing your credit score by 25 points could save you thousands of dollars.
Let’s take a look at the table below, which showcases the average fixed interest rates for a 30-year mortgage at various credit score ranges.
With a FICO score between 620 and 639, bumping your score up to somewhere between 640 – 659 could save you approximately $11,000. That’s a ridiculous amount of savings for a relatively small increase.
Say you instead worked your credit score up to 760-850. This time around, you’d save about $32,000 more than if you had a score between 620 and 639.
Moreover, if your credit score were less than 620, you’d be hard-pressed to find a mortgage. Remember that lenders are taking a risk by giving you money, and they want to minimize that risk by finding people they think they can trust.
Your credit score most definitely plays a pivotal role in deciding your rates and can easily save you lots of money.
|30-Year Fixed Rate $100k Loan (7/7/2020)
|Total Interest Paid On Loan
Furthermore, the Federal Housing Administration (FHA) mortgage requires different down payments depending on your credit score. Individuals with credit scores less than 580 will have to put a 10% down payment. Comparably, those with scores higher than 580 can have a 3.5% down payment.
Notice the trend here? The better your credit score, the more favorable your situation will be. However, it’s worth noting that your credit score isn’t the only determining factor involved. Your income history, loan-to-value ratio, and down payment can also affect your application’s success.
What Is Considered A Good Credit Score For Lenders?
Lenders usually view FICO scores above 760 as good enough to garner the best loan rates available.
At this level, you’ll have access to the lowest interest rates and best payment terms. Lenders will view you as a safe investment and will treat you nicely as a result.
Any score above 760 won’t help you that much. It’s just extra credit at that point.
Wait, So Is My Credit Score The Only Thing That Matters?
No! Other factors, such as the debt-to-income ratio, income history, down payment, and loan-to-value ratio, are all involved in the application and approval process. They give lenders a better sense of your repayment capabilities.
Debt-To-Income (DTI) Ratio
Your DTI ratio is a number representing your monthly debt payments divided by your gross monthly income. Lenders use this number to gauge your ability to make your monthly mortgage payments.
The lower your DTI ratio, the better off you are. Less debt means you have more room to pay for your mortgage.
Lenders such as Wells Fargo have explicitly delineated different ratios to mean different risks:
- 35% or less: debt is manageable; you’re in a good spot
- 36 – 49%: DTI ratio could improve; unexpected expenses could put you in a bad spot
- 50% or more: debt is unmanageable and is taking over 50% of your income
The main takeaway here is that the lower your DTI, the more likely you will be approved and get a lower interest rate.
Lenders want to see that you have a stable employment history.
For instance, if you are sporadically working jobs throughout the year for two months, then a lender might be concerned about your ability to repay your loans. Differently, if you have a steady income for the past two years, then the lender shouldn’t have much to worry about.
In fact, a stable income could help lower your interest rates too. However, the contrary could lead to the opposite or even loan disapproval.
Down Payment And Loan-To-Value Ratio
The loan-to-value (LTV) ratio is a number that represents the mortgage amount divided by the value of the home. The LTV ratio gauges how risky the loan is relative to the property you’re purchasing.
For instance, if you bought a $100,000 home with a $10,000 down payment and a $90,000 mortgage, then your LTV ratio would be 90%.
Generally speaking, you want to strive to keep your LTV ratio below 80%. Pertaining to the previous example, if you had instead made a $20,000 down payment, then your LTV would be 80%. If you made a $30,000 down payment, then your LTV would only be 70%.
The takeaway: the larger your down payment, the lower your LTV ratio. Lenders feel more comfortable loaning money to people with low LTV ratios because it shows them that you have invested a lot of cash.
What Types Of Loans Exist?
Prime Vs. Subprime Mortgages
Subprime mortgages are intended for individuals with poor credit scores. What is explicitly defined as “poor” usually depends on the lender but typically is a score less than 600-620.
From a lender’s perspective, individuals with poor scores are more likely to default on their loans. Consequently, lenders will be more cautious with approving mortgages. Generally speaking, subprime mortgage interest rates will be higher than prime mortgages to cover the additional risk.
Comparably, prime mortgages are for those with good credit scores (higher than 620-650). Prime mortgages provide a plethora of favorable benefits relative to subprime loans, including lower interest rates. Prime mortgages can save thousands of dollars throughout a mortgage’s lifetime.
Different types of loans exist beneath the “parent” categories of prime and subprime loans.
These types of loans are the classic “loan” you think of when you think “loan.”
You borrow money from the lender and make monthly repayments towards that debt over time. The mortgage rates for conventional loans vary wildly depending on your credit history, income, LTV, and DTI ratio.
Conventional loans are usually only approved for those with credit scores higher than 620 and generally require a down payment.
These loans are for people with all ranges of credit scores. The difference lies in the required approval down payment.
Per the FHA website, your credit score determines the down payment:
- Credit score greater than 580: 3.5% down payment
- 500 – 580: 10% down payment
FHA loans are popular because they generally have lower down payments and credit scores. However, with this leniency comes some tight restrictions and more fees.
These loans charge two additional insurance fees:
- Upfront Mortgage Insurance Premium (UFMIP): one-time charge of 1.75% of the base loan amount
- Annual MIP: monthly payments (yes monthly, ignore the name) ranging between 0.45 to 1.05% of the base loan amount
Are FHA loans better than conventional loans? That isn’t a question that can be generalized to everyone. Make sure to look at all your options closely and carefully to determine your answer.
The United States Department of Veteran Affairs (VA) offers specialized loans. VA loans are geared towards veterans, service members, the National Guard, and reserve members. These loans typically provide nicer terms compared to some others but still require some degree of income and credit history.
About 90% of VA loans are made without a down payment. Comparably, all FHA loans require some degree of down payment. VA loans definitely have benefits.
VA loans split into two categories:
- Direct Loans: The government acts as your direct mortgage lender
- Backed Loans: The government stands behind your loan to minimize the lender’s risk. If you default on your mortgage, then the government will staunch the lender’s losses
These mortgages were created by the United States Department of Agriculture (USDA) to “stimulate economic growth in rural and suburban communities.” USDA loans offer low-interest rates and don’t even require a down payment. If you can qualify, these mortgages offer a lot of perks.
However, while these benefits seem exciting, USDA loans are harder for individuals with lower credit scores. Furthermore, USDA loans require insurance payments alongside monthly debt repayments.
- Insurance: 0.35% of the loan principal
Don’t be discouraged by the word “agriculture.” You can check your eligibility for free at any time. In fact, over 100 million Americans are eligible by location.
Can I Get A Co-signer For A Mortgage? How Do Co-signers Help?
You can generally get a co-signer when applying for a mortgage.
While co-signers will help your mortgage application, they need to be aware of the burdens they face when placing their credit history on the line.
Lenders are more inclined to give mortgages to co-signed applications because it alleviates a lot of risks. If you default on your loan, then your co-signer has to take responsibility. Your co-signer likely has shown the lender that they can pay off your loan if you can’t.
For instance, say you have a credit score of 500. You’ll be hard-pressed to find reasonable mortgage rates, let alone even being approved.
However, say your dad has a credit score of 850 with a steady income and a low debt-to-income ratio. Your dad could co-sign your mortgage application. Now, lenders would be more than happy to fork over a loan because they can chase your dad for money if you fail to pay your mortgage.
How Can I Improve My Credit Score Before I Buy A Home?
There are many ways to work on your credit score before buying a home. However, techniques to improve your credit score vary by how much time you have before you plan to apply for a mortgage.
Pay Off Any Credit Card Debt
Your credit card utilization ratio comprises 35% of your credit score. The ratio is representative of your credit use divided by your total credit limit.
For example, if you have a credit card with a credit limit of $10,000 and use $1,000 of your credit line, then your utilization ratio is 10%. The lower your credit utilization ratio, the higher your credit score.
The great thing about the credit utilization ratio is that you can quickly boost your credit score by minimizing your utilization. The utilization ratio can rapidly change if you play your cards correctly.
A month or two before you apply for a mortgage, pay off all of your credit card debt. This move will put your utilization ratio near 0%, tremendously helping your credit score.
Become An Authorized User
Say you have a poor credit score, but your mom has an excellent credit score. She has had a credit card for over 20 years, hasn’t missed a single payment, and has a low credit utilization ratio.
Your mom can add you as an authorized user on her credit card. This addition would give you a significant boost to your credit score by adding all that positive data to your credit history. Simply put, your credit score will piggyback off of other’s excellent credit histories.
Becoming an authorized user will affect your credit score almost immediately. Consequently, if you need a quick boost, you could try finding someone willing to add you as an authorized user.
Open A Credit Card With Good Habits
Getting another credit card on your history has multiple benefits if you maintain good credit card practices.
Firstly, your credit card utilization ratio will decrease. Since having another card will increase your total credit limit, the denominator in your credit card ratio will increase. This will then reduce your utilization, boosting your score.
Next, if you maintain a good repayment history, then the payment history of your credit score will also improve. Not missing a single payment across the year will give your credit score a small increase.
Finally, adding a credit card could help your credit mix. The types of credit you own affect your credit score, and adding more variety can assist your credit score as well.
However, opening a credit card could hurt your credit score. Don’t open too many cards in a short time window. 10% of your credit score factors in how many times you’ve opened new lines of credit, so the positive gains you might get could be offset by the negative hard inquiries.
Opening a new card will probably have a tangible effect on your credit score after just a few weeks, but the positive results will increase the longer you wait.
Find A Credit-Score Building Loan
These specialized loan products are offered for individuals with poor credit history but can help almost everyone.
Credit-score building loans can:
- Improve your repayment history if you make the appropriate monthly payments
- Diversify your credit mix even more by adding loans
The positive benefits will probably appear on your credit score after a few weeks or months.
Check Your Full Credit Report For Errors
Sometimes the credit bureaus make mistakes that can really hurt your credit score.
According to the Federal Trade Commission, about 20% of consumers have errors in their credit score reports. Consequently, it’s essential to take a deep dive into your full credit report whenever you plan on applying for a loan or credit card to see if there are any errors there.
Otherwise, an unknowing mistake could cost you thousands of dollars or failure to be approved.
Unfortunately, correcting errors can take a few months. If you plan on buying a home, it’s worth taking a look at your credit report several months beforehand to find any pesky mistakes.
Use Credit Score Boosting Tools
Disclaimer: some of these tools may cause unintended consequences. For example, ExperianBoost has been noted to worsen your debt-to-income ratio since the VantageScore isn’t universally used as much as the FICO score.
ExperianBoost is a free-to-use tool that factors in other on-time utility and telecom payments. You can leverage this to bolster your VantageScore’s payment history.
The effects are factored into your credit score almost immediately and could help put your VantageScore in a better position.
How Can I Track My Credit Score?
There are many ways to track your credit score for free.
Credit Karma and Credit Sesame are entirely free to use and provide reliable updates on your credit score. LifeLock takes credit score tracking to a whole new level by charging a monthly fee for identity theft protection and insurance.
ExperianBoost also offers credit score tracking privileges alongside its credit score boosting benefits.
Keeping an eye on your credit score is generally a good habit. You never know what could happen these days, and it’s always best to err on the side of caution.
John Ta is an undergrad at the University of Pennsylvania and the founder of Penn’s first undergrad personal finance club, Penn Common Cents. As a first-generation college student, he had to learn everything about personal finance on his own and seeks to mend the financial literacy knowledge gap seen almost everywhere. John is currently studying for an MS in Chemistry and a BA in Physics (business & tech concentration), Biochemistry, and Biophysics and is interested in the intersections of finance and healthcare.