Credit Scores – everybody’s favorite topic. While you may, or may not, agree with that statement, at some point we all have to accept the role that our particular credit score plays in obtaining a mortgage.
Credit plays a huge role in getting a mortgage because it is a variable lenders use to determine the likelihood that the loan will be repaid on a timely basis. Credit bureaus evaluate people's credit worthiness using a FICO Score*. The higher the score the better the borrower's credit.
The mortgage rate charged to a borrower depends on their credit score. There is an inverse relationship between credit score and interest rate changed. The higher the score the lower the rate and the lower the score, the higher the rate.
Two separate buyers with the same income, purchasing the same price home may both be approved by the lender, but they may be charged different interest rates based on their credit scores.
You could save thousands of dollars over the life of a loan by improving your credit score by just a few points. A $350,000 mortgage at 3.5% has a principal and interest payment of $1,571.66. By improving your credit score to qualify for a 3% rate, it would save $96.04 a month.
Over the life of the mortgage, that would save $34,575 in interest. Improving your credit score to shave 0.25% off the rate would make it worthwhile.
Of course there are several factors that go into your FICO Score but let’s take a look at a couple; Credit Utilization & Payment History.
Credit utilization is the percentage of total credit used compared to the total credit available. If you have a $2,500 balance on a credit card with $10,000 available credit, your utilization rate is 25%. Ideally, it should be 10% or below. This ratio accounts for 30% of a person's FICO score.
Credit utilization is calculated using the balance on the monthly statement so paying it off in full every month could still result in a high CU score. Some credit counselors suggest paying down the balance before the end of month statement comes out. A trusted mortgage professional can make specific recommendations like how to improve your credit utilization.
Your credit score can be adversely affected if your credit limits are lowered. You may have the same monthly outstanding balance you have had for years but it now becomes a larger percentage of your available credit and your score goes down. In the example used earlier, if the available credit was lowered to $5,000 and your balance is $2,500, the credit utilization is now 50%.
Payment history is the largest contributor and counts for 35% of an individual's FICO score. It is an indication of your likelihood of paying on time and as agreed for your debt, especially mortgages, credit cards, student and car loans, among others.
A big shock to some borrowers is to find out that while they may have never actually incurred a late fee because of a grace period, their score could be dinged because it was not paid on time of the actual due date.
Foreclosures, deeds in lieu of foreclosure and bankruptcies will affect a borrowers payment history as long as they appear on the credit report.
Americans are entitled to a free annual credit report by law from the major credit companies: Experian, TransUnion and Equifax. AnnualCreditReport.com is the source for these federally authorized reports. During the Covid-19 pandemic, they are offering free weekly reports.
Even if you are not buying a home or getting a mortgage currently, it is a good routine to check your credit report periodically to discover signs of identity theft early.
* FICO, originally Fair Isaac & Company
For more information regarding how your score is calculated and what components make up the FICO Score, here are a couple of links for your reference:
What Factors Make Up Your FICO Score (Motley Fool)