Along with having a down payment, your credit score is probably the most important factor for a home mortgage. Just like saving a down payment, it can also take some time to repair your credit score if you need to or improve it to obtain a better interest rate that translates into a lower monthly mortgage payment.
With home prices as high as they are today and with interest rates hovering between 5.5% and 6.3%, managing your credit score is critically important for both qualifying for a mortgage and being able to afford the monthly payments.
Not only do you need at least a minimum credit score to qualify for a mortgage, but the interest rate that you will pay is also determined in a large part by how high your credit score is. For most mortgages, the minimum credit score needed to buy a house is 620. There are a few lenders that will allow you to qualify for an FHA loan with a score below 600 but these are very few and far between. A higher score significantly improves your chances of approval. Borrowers with a score under 650 only make up a small number of homebuyers who ultimately close the purchase of a home. Every way you look at it, the higher you can raise your credit score, the better off you’ll be before locking in a mortgage.
For example, a $350,000 30-year mortgage at 6.3% will have a $2,166 monthly payment (without property taxes and insurance). That same $350,000 loan at 5.5% will have a $1,987 monthly payment. The monthly difference of $179 might not seem like much at first glance but it can make a substantial difference. From a lender's debt-to-income perspective, that amount doubles because your monthly debt goes up by $179 and your monthly spendable income goes down by the same amount. From your personal financial perspective, it means you have $2,148 less to spend each year.
Different lenders have slightly different criteria for assigning interest rates to credit scores. Generally, the range looks something like this:
An example of interest rates for different scores would be something like a score between 660 to 679 being given an interest rate of 5.36%. A score between 620 to 639 is given an interest rate of 6.34%. If your score is on the cusp of these general ranges, it is worth the effort to shop around for a lender that has a breakpoint that gives you a better interest rate.
If your score is already in the 700s, you’re in decent shape — but you may be wondering how to take your score from good to great. There are different credit scores used by lenders but by far the most common is the FICO score which operates on a scale from 300 to 850. Trying for a perfect score is almost impossible and probably not worth the effort. However, striving for a score in the high 780s to 800+ can be worth your time.
These tips assume you’ve already done what is needed to bring your score up to at least 690 or 700 — meaning you don’t have a bankruptcy, you’ve cleaned up any errors on your credit report, etc.
Tip #1. Always pay on time. Always. With an already decent score, this is the most influential factor to improve it even more. On your credit report, late payments are known as “delinquencies.” They stay on your report for 7 years but the older these are, the less they count towards your current score. Most have little impact after 2 years. Remember everything on your credit report is automated so being even a day late will make the payment delinquent. This can be a good reason to use automated payments if you aren’t always prompt about paying your bills on time. Having a checking account that automatically draws from your savings account when needed can also be a good idea.
Tip #2. Don’t close old accounts. These can show a longer history of you being a responsible borrower. Having the balance available also helps your credit utilization ratio (see below). In most cases, having older (including unused) accounts on your report will boost your score.
Tip #3. Pay attention to your credit ratio. This is the difference between your credit limit and the current balance you owe. The general rule of thumb with the credit ratio is to stay below 30% utilization. That means that if your limit is $10,000, your balance should be around $3,000. You can improve this by either wisely increasing the limit or more wisely, decreasing the amount that you owe.
Tip #4. Continue monitoring your credit score for errors. You’d be surprised how many and how frequently errors are reported on people’s credit reports. At a minimum, pull your free annual report from each major reporting agency. If you have to pay for an up-to-date copy shortly before applying for a mortgage, it can be worth the small fee. Do this about three months before applying for a mortgage because it takes time to have errors removed.
Tip #5. Establish a good mix of credit types. This is a good indication to lenders that you are among the most responsible borrowers. All types of credit are not the same when calculating your credit score. Different common types of credit include unsecured credit cards, secured car loans, and personal loans. Store credit cards are at the low end of the spectrum and needing a co-signer is even less desirable. But… you do need to have credit to improve your credit score. If you have paid off all your debt, good for you. However, you might want to consider opening a credit account to keep your score current. This could be taking out a low-interest loan that you know you can pay on time, every time. Maybe instead of paying all cash for a car, make a big down payment and take on a small loan. Or a credit card that you can make a small charge on each month and keep the ratio of the amount borrowed to the limit at close to 30%.
In the end, on-time payments and your credit ratio tend to have the most impact when you are trying to move your good credit score to great.
What is your advice for improving a credit score from good to great? Please leave your comment.
Also, our weekly Ask Brian column welcomes questions from readers of all experience levels with residential real estate. Please email your questions, inquiries, or article ideas to [email protected].