Many people who are planning on buying a home don’t fully understand the impact their credit situation can have on their ability to qualify for a mortgage. Because it’s vital to recognize the value of having good credit before you submit your first mortgage application, let’s find out what your credit is and why it matters so much.
Understanding Your Credit
From a lender’s viewpoint, your credit situation is affected by your income, any legally binding financial agreements, credit report, and credit score. In a nutshell, lenders will consider your gross monthly income to determine your financial reliability. On the other hand, legally binding financial agreements refer to all the loans, including mortgages, credit cards, personal loans, car loans, student loans as well as rent, medical bills, alimony, and any other regular payments that you must make.
The credit report shows the amount of money you’ve borrowed and how you’ve paid your loans over their terms. Because the credit report indicates how likely you’re to repay a new loan on time, lenders rely on it when determining your creditworthiness.
Your credit score will play a significant role in securing a mortgage. Also referred to as FICO score, it can range from 300 to 850 points and is affected by:
- How you have used and managed credit in the past; late payments will lower your score;
- The total amount of debt that you owe and type of credit that you currently use; the more debt you have, the lower your credit score will be;
- How often you’ve applied for and taken on new debt; besides the fact that your credit score can be adversely affected by hard inquiries, lenders consider multiple loan applications as a sign of risk.
Because every single financial expert would advise you to start building good credit a few years before you apply for a mortgage, let’s find out why good credit is important.
Good Credit Will Save You Money
Currently, the minimum credit score required to qualify for a conventional mortgage is 620. However, credit score minimums can run higher, depending on your DTI ratio and down payment amount.
A noteworthy point is that a score of 620 doesn’t guarantee a lower interest rate. In fact, the credit score is inversely proportional to the interest rate and amount you’ll need to put down on the home you wish to purchase. This means that conventional mortgage lenders usually charge a lower interest rate and down payment for a higher score, which is typically referred to as “risk-based pricing adjustment.”
To fully understand how big a difference your credit score can make in your monthly mortgage payments, let’s consider a 30-year, fixed-rate mortgage, with 20% down ($76,000), on a $380,000 home. In this case, the interest rate on the loan principal amount ($304,000) and your monthly mortgage payment will fluctuate according to the credit score, as you can see in the table below. *
Based on these numbers, the total interest you’d end up paying is nearly $100,000 more over the life of the loan if your credit score is below 640, compared to the interest rate charged for a score ranging between 760 and 850. Even if your score is in the “fair” range, you’ll still feel the financial impact of having a less-than-perfect score. For instance, the difference in total interest that you’d need to pay between a score of 660 and 700 is still more than $23,000 ($172,831 - $149,649).
The amount of total interest over the life of a conventional mortgage depends not only on your credit score but also on the annual percentage rate (APR) as well as national mortgage rate, which can change on a daily basis. The higher these rates, the more you’ll pay in interest over the loan term.
Besides saving you money in interest, good credit allows you to qualify for loans that have more lenient credit score and income requirements, such as FHA and VA loans. As an example, to qualify for an FHA loan with a 10% down payment, you’ll need a FICO score of at least 500. A minimum score of 580 is typically required for an FHA loan with a 3.5% down payment. As well, to qualify for a VA home loan, which doesn’t require a down payment, an applicant needs a FICO score of at least 640 and sufficient income.
If you’re seriously thinking of homeownership, remember that a lower score translates not only into a higher down payment but also into a higher interest rate, which will end up costing you a lot over the loan term. Therefore, doing everything you can to improve your financial profile before applying for a mortgage is well worth the effort! To find out how you can boost your credit score or to apply for a mortgage, contact our professionals today!
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