There's a big difference between having an excellent credit score of 740 and the riskier low score of 620.
Not only will the home buyer with the low score have a higher interest rate and mortgage payments, but the closing costs will be more as they pay points to the lender so they can get a lower interest rate.
Lower score pays more for same rate
Consider a $300,000 conventional loan with 20% down on a $375,000 home. To get a 30-year fixed rate of 4.65 percent (under recent market conditions), a borrower with a 620 credit score would need to buy 3 discount points, at a cost of $9,000, according to Joe Parsons, a senior loan officer at PFS Funding in Dublin, CA. But a borrower with a 740 credit score could get the same rate by paying only 0.25% in points, or $750.
To get around the cost of paying points, most borrowers will accept a higher interest rate and slightly higher monthly payment. In the scenario above, a 740 credit score would allow them to pay no points for a loan at 4.875% interest and a $1,588 monthly mortgage payment.
To get the same loan rate, a borrower with a 620 credit score would have to pay 2.75% points, or $8,250 more in closing costs, Parsons said. As an alternative, they could go with a higher mortgage rate - the highest being 5.25% for a $1,657 monthly payment - but even then would still have to pay 0.7 % in points, or $2,100 in this scenario.
Having a good, bad or mediocre credit score can be the difference between getting approved for a loan or having to wait on the sideline to improve your credit.
"If somebody is just right on the cusp, picking up five to 10 (credit score) points may save them $1,000," Parsons says.
Interest rates can change a few times daily, but a quote in mid-August from Herb Ziev, a residential mortgage loan originator in Plano, Texas, showed interest rate changes for different credit scores. For a $375,000 loan with 20% down, a 690 credit score would equate to a 4.75% interest rate and a $1,564 monthly mortgage payment.
A 720 credit score wold have a 4.625% interest rate and $1,542 mortgage each month, and a 760 score would have a 4.5% interest rate and a $1,520 monthly payment.
"A credit score is one of the things that's a deal breaker," Ziev says.
"If you have a low credit score, other than improving your credit, there's nothing you can do, in order to get a better rate," he says.
Savings, income won't lower your rate
Other than buying down the rate, there's not much more than improving their credit score that someone with a score of 650 or less can do for a conventional loan, Ziev says. Additional assets will help someone qualify for a loan, but they won't get them a lower interest rate, he says.
"Mortgages are generally income based, they're not asset-based," he says. Low credit scores mean higher default rates on home loans, he says.
"It doesn't really have to do with how much money you have, or how much money you make," Ziev says. "It really has to do with risk."
For someone with a low credit score, compensating factors such as having a high amount of savings or having a high-paying job can help make them approvable for a loan, but they won't help get a better interest rate, says Greg Cook, a lender who specializes in helping first-time buyers.
A home loan approval is based on the totality of a borrower's financial profile, Cook says. This includes consistent, verifiable income and a demonstrated ability to save, along with a credit score. The down payment and credit score have the two biggest effects on a loan rate, with a higher down payment needed if a borrower has a low credit score, he says.
Improving your score
The best way to get around a low credit score - and thus a high home loan rate - is to improve the credit score, which can take time, loan experts say.
For someone with a lot of credit cards and credit card debt, a credit score can increase by 70 to 80 points by paying off the cards, he says.
"Sometimes it's as simple as going back and negotiating if you have an outstanding collection," Cook says.
Six to 12 months of paying down credit balances and not having late payments will significantly affect a credit score, says Cyndee Kendall, regional sales manager in Northern California in the mortgage banking division at Bank of the West.
Having a high percentage of credit balances to available credit can be fixed in a month by paying down credit balances, Cook says. The ratio should be 30 percent or less, he says.
A borrower can have three different credit scores from the three credit reporting agencies, but lenders usually use the middle score.
Borrowers with low credit scores have the most to gain by improving their scores, Kendall says.
Easier approval on FHA, VA loans
First-time buyers with low credit scores can get FHA and VA loans that aren't dependent on credit scores, though credit history is taken into account, Kendall says. For an FHA loan, a credit score in the low 600s is as low as they can go to get a loan, Ziev says.
"They can get a better interest rate," Cook says of borrowers of the federal government's backing of FHA loans, "but they're going to have to improve their credit score."
What shouldn't be done to improve a credit score is to get rid of credit cards entirely, experts say, though not using them for awhile is a good idea if it can help the user pay off the balance quicker. It's almost a Catch-22, but you need credit to get more credit.
"If you've got no credit history, then people aren't going to give you credit," Ziev says.
(note: Mortgage rates may change rapidly. All rates cited above are based on market conditions at the time of the conversation)