A good credit score doesn't just help you get a home loan. It can also have a big effect on your mortgage rate as well.
Home buyers with low credit scores not only have more trouble getting a loan, they end up paying higher mortgage rates and monthly payments as well. Or they pay higher closings costs when pay points to the lender so they can get a lower interest rate.
It's a good idea to do a credit score check before applying for a mortgage. Knowing your credit score will give you an idea of what sort of mortgage rate you can get and whether you should seek to do some credit score improvement before applying.
What is a good credit score?
Your credit score is a three-digit number that tells lenders how likely you are to repay your loans. The most common credit scoring system is the FICO score, which assigns you a score of 300-850 based on your credit history.
A good credit score is generally regarded as a score above 700 – over 740 is excellent. Anything below 620 is considered risky, and 580 and below is rated as bad. And there are gradations in between, with each step down reflecting higher rates or loan costs.
There are a few ways to check what your credit score is. You can order your FICO score directly from the credit reporting agencies – Equifax, Experian and Transunion – but you'll often have to pay for it (non-FICO scores using other scoring methods are sometimes offered free of charge).
Fortunately, many credit card companies and banks now include a "what is my credit score?" section on your monthly statement or when you log onto your account online. This provides your most recent FICO score, updated monthly, and tells you which credit reporting agency it came from.
Your credit scores are different from your credit reports, which are the actual records kept by the three agencies. By law, you're entitled to a free copy of your credit report from each of them once a year. It's a good idea to do so to check for errors and signs of unauthorized activity – you can get them through the official site, www.annualcreditreport.com, which is maintained by the agencies themselves.
Lower score pays more for same rate
So how does credit score affect your mortgage rate? Consider a $300,000 conventional loan with 20 percent down on a $375,000 home. Under recent (2013) market conditions, a borrower with a 740 credit score could get a rate of 4.875 percent with no points on a 30-year fixed-rate loan, according to Joe Parsons, a senior loan officer at PFS Funding in Dublin, CA, for a monthly payment of $1,588.
But a borrower with a 620 credit score would have to pay 2.75 discount points to get the same rate – adding $8,250 to the closing costs. As an alternative, Parsons said, 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.
That might not seem like a huge difference in monthly payments, but over a 30-year loan, that extra $68 a month works out to nearly $25,000 in additional loan costs.
If you don't have a good credit score, you might be better off waiting on the sideline for a while to improve your credit. Mortgage rates on conventional loans go up in steps as credit scores decline. If a check on your credit score shows you're just below a cutoff, a slight improvement could save you a lot of money.
"If somebody is just right on the cusp, picking up five to 10 (credit score) points may save them $1,000," Parsons says.
Savings, income won't lower your rate
Other than buying down the rate with discount points, there's not much more than a credit score improvement that someone with a score of 650 or less can do to reduce the rate on a conventional loan, according to Herb Ziev, a residential mortgage loan originator in Plano, Texas. 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 them qualify 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.
How to increase your credit score
So if you've looking at a high rate on a home loan, you're probably wondering can be done to increase your credit score. That usually takes time, loan experts say, but in some cases it's possible to fix a credit score fast.
Credit score improvement can be as simple as reducing your debt load. 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, Cook says.
"Sometimes it's as simple as going back and negotiating if you have an outstanding collection," he said.
Credit utilization, or how much of your credit limit you're using, has a significant effect on your credit score. 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.
One mistake some people make when trying to improve their credit score is canceling unused credit cards. But this can hurt you by wiping out the available credit on that card – meaning you have less credit remaining overall, so your credit utilization increases.
A credit score improvement doesn't necessarily have to take a long time. Six to 12 months of paying down credit balances and not having late payments will significantly improve a credit score, says Cyndee Kendall, regional sales manager in Northern California in the mortgage banking division at Bank of the West.
Checking your credit reports for errors can sometimes allow you to repair your credit quickly. That's assuming there are errors to find. But things like payments not credited to an account or a report of a disputed debt you don't actually owe can really drag down your score – so correcting those can produce a significant credit score improvement. See the "What is a good credit score?" section above for information on how to check on your credit score and get your credit reports.
Easier approval on FHA, VA loans
First-time buyers with low credit scores can get FHA and VA loans that aren't as 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 a while 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)