- August 16, 2017
- Posted by: steve
- Categories: credit score, mortgage rates
Can your credit score affect your mortgage rate? If so, how do you make it work in your favor? Learn all the ins and outs right here.
Entering into home ownership is both a dream and a tremendous amount of work. This is true even before you visit your first open house.
A house is a massive investment. It requires most people to take out a mortgage. That means talking with lenders to find out about mortgage application options and organizing a lot of financial paperwork.
This is as true in Los Angeles and Chicago as it is in here in Palm Beach.
Dealing with the finances up front is a wise move. After all, it doesn’t do any good to track down your dream home if no lender will finance the purchase. It happens more often than you might think.
Something else that happens all too often is a credit score derailing a home purchase. It’s an understandable, if unfortunate, outcome.
How often have you asked, “How do lenders view credit scores in terms of mortgage rates?”
If the answer is never, it’s time to settle in and see what your credit score really means for your mortgage prospects.
Credit Score Primer
Before we get into the nitty-gritty of questions like, “How do mortgage rates change with different credit scores?”
It’s important to first understand your credit score.
The very basic explanation is that credit scores are numbers from 300 up to 850 that tell lenders how risky it is to lend to you. You can think of it like an old arcade video game. High scores are good, while low scores are bad.
The problem is that explanation leaves a lot to the imagination in terms of how do you get that life-altering score in the first place. While there are exceptions, most lenders still rely on FICO scores.
A FICO score is based on five weighted categories. Payment history, debt, and credit history age make up 80% of the score. New credit and your credit mix — the types of credit you have — make up the other 20%.
The credit bureaus take all the information they have about you in those categories and run it through an equation or algorithm. The math produces a three digit number at the other end. That number is your credit score.
If your number is over 700, that means you’ve done a good job of paying bills on time, managing your debt and limiting your applications for new credit.
If your score is below 700, it means that you’ve probably had some kind of financial trouble in the past.
Mortgages and Credit Scores
If you were wondering at all, credit scores do change your mortgage rate. They also impact your ability to get approved for a mortgage.
Getting approved for a mortgage depends on your credit score as much as your ultimate mortgage rate. If you can’t hit the minimum threshold, the rates won’t matter.
You might be wondering, “How do I know whether my credit score is good enough to even get a mortgage?” For practical purposes, the lowest credit score that will get you a mortgage is a 620.
In theory, the FHA has a lower credit score requirements of 500. Those loans and most mortgages are issued through vendors, who apply lender overlays that drive up the minimum score.
Lender overlays are additional requirements that lenders impose before approving a loan.
The additional requirements protect the lenders from what they view as unacceptable risks.
A number of things can trigger overlays including erratic work history, high bills relative to income, and a short credit history. A fresh college grad with a mountain of student loan debt, a history of summer jobs, and a 4-6 year credit history is going to look like a risk.
A way to think of overlays is to think about teenagers driving.
The laws say that teenagers must do certain things, such as a pass a written test and driving test. If they pass, they can drive freely. Parents and insurance companies may see it differently.
Parents often put a lot of restrictions on when and where a teenager can drive. Insurance companies make a practice of hiking up the insurance rates to offset potential risk.
When it comes to a minimum credit score for approval, lenders are acting much as parents or insurance companies. They set additional boundaries and expectations before providing the loan.
Assuming you hurdle the lender overlays and get approved, your credit score still matters in terms of the mortgage rate.
For the best mortgage rates, you need to be coming through the door with a credit score of around 740. This score makes you a low risk because your financial history needs to be very sound to get this score.
Once you drop below 740, you bump up against something called a loan level price adjustment. If you want to kill some time, you can go read the Federal Housing Finance Agency’s overview of the fees and look at the fee schedules. Here’s the short version.
As your credit score moves down from 740, your mortgage interest rate goes up. If your score is 700, the increase is small. If your score is 620, you could be looking at as much as a 1% increase from the base rate.
If the base interest rate is 3.6%, a 740 will probably get you a 3.6% rate or something in that neighborhood. A 620 will probably get you something in the 4.6% neighborhood.
That doesn’t seem like a big difference when you write it that way. How do you know it’s going to cost that much more out of pocket in the long run? Let’s do a little math to see how the numbers look.
Let’s say you want to borrow $150,000 dollars to buy a house.
At 3.6% over 30 years, the monthly payment works out to $682. You’ll end up paying $245,508 over the life of the mortgage.
At 4.6% over 30 years, you pay $769 per month. You end up paying $276,828 over the life of the loan.
That extra 1% will cost you an extra $31,320 over the life of the mortgage. Bear in mind, that’s just the base rate.
Private Mortgage Insurance
If you make a down payment that is less than a certain percentage of the value of the home, you’ll be required to get private mortgage insurance.
Just like the interest rate of the loan itself, your premium for PMI also depends on your credit score. As a general rule, the lower your credit score, the higher the premium. This amount is tacked onto your monthly payment.
Let’s say your mortgage is at the 4.6% level and your premium is $120 per month. Your monthly payment just jumped from $769 to $889.
That payment isn’t forever. Depending on the loan, PMI gets canceled when the amount owed is less than 77% or 78% of the property’s original value. That still works out to years of payments at the higher rate and drives up your total costs.
Let’s say it takes you five years to reach that magic percentage. You’ll pay out an extra $7,200. Most people can find better uses for seven grand.
Unlike a mortgage, which is almost always necessary to buy a home, PMI isn’t mandatory. How do you avoid it?
Save up until you can put down 20% of the value of the home. Putting down that much typically excludes you from the PMI.
Government loans have their own insurance program built-in, which means PMI isn’t a concern with those.
How Do You Tilt the Odds in Your Favor
You don’t want to pay more than you need to, so how do you make things more favorable for you in the mortgage process?
You plan ahead and work to improve your credit score.
The planning ahead phase is about deciding when you expect to buy a home.
It’s common for people in their twenties and even thirties to move several times for career opportunities. So let’s say that you’re in your early-mid thirties. You’ve started thinking it’s time to buy a house.
Give yourself two or three years before you get serious about house hunting. Those years give you time to do two critical things.
You get time to save up money toward a down payment that will avoid PMI requirements, which can save you thousands of dollars in unnecessary costs. It also gives you a chance to do some repair work or simply burnish your credit score. Remember, the closer to 740 you are, the better your mortgage rate.
There is no magic fix to credit score problems, but you can increase it incrementally over three years. How do you do that?
Here are some of the greatest hits:
- Pay everything on time, even it means setting up automatic payments
- Chip away at your overall debt
- Get those credit cards below 30%
- Get errors taken off your credit report
After three years of active efforts at improvement, it’s almost impossible not to see your credit score go up.
It’s an important question. How do mortgage rates change with different scores?
The answer is that they change a lot. Depending on the house, the loan and your down payment, that change could mean paying tens of thousands more or less for the same property.
It might mean waiting a little longer to buy a home, but taking the time to work on that credit score will pay off when you apply for the loan.
New Florida Mortgage specializes in helping people find the best mortgages for their individual situation. If you have mortgage questions or want to comment, contact us today.