A Better Credit Score Could Make Mortgage Refinancing Worthwhile
Falling interest rates can be reason enough to refinance a mortgage loan. So can improving your credit score, even by just 50 points by simply paying all of your bills on time for a year. Raising a credit score only 20 points can lower a monthly mortgage and save thousands on interest paid over the life of a home loan.
If you bought your home when your credit score was low, you likely got a home loan with a higher interest rate than you would have with a higher credit score, since lenders use the scores to weigh the risk of providing loans.
If you’ve missed rent payments in the past or just one mortgage payment was 30 days late, it would be reported to the credit bureaus and could cause your score to drop. But for people with low credit scores, they could benefit the most by making on-time mortgage payments for a year and could see their credit scores improve enough to warrant refinancing into a better loan, says Andrew Weinberg, principal at Silver Fin Capital Group, a mortgage brokerage in Great Neck, N.Y.
“They want to see that you can use credit responsibly,” Weinberg says of lenders. “So making 12 mortgage payments on time will help.”
Credit a bigger factor in conventional loans
High credit scores are less important for FHA and VA loans, which are government-backed loans meant to help first-time buyers who may have credit problems. A middle-of-the-road credit score of 620-640 is OK with such loans instead of a “good credit” score of 740, Weinberg says.
Federal Housing Administration loans require mortgage insurance if borrowers put down less than 20 percent. To get out of paying mortgage insurance premiums, borrowers will either have to have their home equity increase to 20 percent or qualify for a different loan.
A conventional loan is often the next option. Conventional loans are eligible for purchase by Fannie Mae or Freddie Mac, and there’s an industry standard table of rate adjustments based on a borrower’s credit score, says Brian Mitchell, a licensed branch manager at Angel Oak Home Loans in Wilmington, N.C.
On a 20 percent down payment purchase, Mitchell says, a borrower with a 639 credit score would pay an extra 0.325 percent of the loan amount in closing costs to get the same interest rate as someone who has a 740 credit score. That would be $6,500 on a $200,000 loan.
To avoid the extra cost, the 639-credit score borrower could take a higher interest rate, which in his example would translate to 1.25 percent. That increases the monthly mortgage by $149 for 30 years.
Sample effects of credit scores on mortgages
An online credit score loan savings calculator created by FICO, one of the main credit scores looked at by lenders, can quickly show you how much can be saved on a mortgage rate by improving a credit score.
For a $200,000 loan, the national average the calculator currently gives for a 30-year fixed rate loan for sample credit score ranges are (assuming at least 20 percent home equity):
- 760-850 FICO score: 3.847% APR, $937 monthly payment, and $137,419 in total interest paid.
- 700-759: 4.069%, $963 per month, $146,609 total interest.
- 680-699: 4.246%, $983 per month, $154,028 total interest.
- 660-679: 4.46%, $1,009 per month, $163,104 total interest.
- 640-659: 4.89%, $1,060 per month, $181,686 total interest.
- 620-639: 5.436%, $1,128 per month, $205,922 total interest.
Someone with a low credit score of 640-659 could save an extra $18,582 over the lifetime of their loan by improving their credit score 20 points and then refinancing into a new loan.
How to best improve a credit score
Many things can improve a credit score: Paying down credit card debt and outstanding delinquent balances, removing errors from your credit report, not opening a lot of new credit at the same time, and paying your bills on time.
Since a mortgage payment is likely your largest bill, paying it on time each month is key to improving your credit score if you’ve been late making rent payments in the past or have been more than 30 days late making a mortgage payment. Payment history, or making on-time payments, accounts for 35 percent of a typical credit score.
“Mortgage is very important,” Weinberg says. “If you’re going to miss anything, don’t make it that.”
Lowering a credit utilization rate — which is how much of their available credit a borrower is using — can help a lot too. Ideally, using less than 30 percent of the credit available to you on a credit card, for example, is best. Credit utilization makes up 30 percent of a credit score.
People who are new to credit or who have low credit are most likely to see the biggest jumps in their credit scores by making positive changes, says Sean Messier, a credit industry analyst at Credit Card Insider.
Some lenders may check multiple scores, Messier says, so it can be worthwhile to know that improving your credit utilization rate will help you more on a FICO score where it’s worth 30 percent of your score, versus 20 percent on a Vantage 3.0 credit score. Vantage, however, gives a little more weight to on-time payments.
Most credit score changes take a few months to take effect, Weinberg says, so check your credit score before checking if refinancing your loan is worthwhile. If you’re in a rush, a rapid rescore can be done in a few days.
Of course, a credit score isn’t the only consideration by lenders in determining your loan rate. Other factors include down payment amount, monthly debt load, property type and size of loan. Come up with a higher down payment, for example, and your interest rate will likely be lower
It’s also worthwhile to do some simple math to see if refinancing your loan is worthwhile. Closing fees typically cost 2 to 5 percent of the purchase price, so refinancing a $150,000 loan could cost between $3,000 and $7,500 in closing costs.
If you don’t plan to live in your home for much longer, then refinancing isn’t worth the expense. To cover $6,000 in closing costs by saving $100 per month in mortgage payments would require living there five more years before seeing the benefits of refinancing: 6,000 divided by 100 is 60 months, or five years.