From Credit to Keys: How Your Credit Score Impacts Your Mortgage
Updated: December 29, 2023
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A mortgage is a type of loan used to buy or refinance a home. Unlike personal loans or credit cards, mortgages are secured by the property itself. Mortgages come in various forms, including conventional, FHA and VA loans, each with distinct requirements. Mortgage lenders look at many factors before offering a loan — your income, debt, employment and, importantly, your credit score.
This guide focuses on your credit score and its role in obtaining a mortgage. In addition to exploring the impact of your credit score on your mortgage, we also share practical steps you can take to improve your credit and chances of approval.
How Your Credit Score Shapes Your Mortgage Journey
Your credit score, a three-digit number between 300 and 850, is a snapshot of your credit history. It’s like a financial report card that reflects your borrowing behavior.
Generally, scores above 670 are considered good, while those below 580 are seen as poor. FICO and VantageScore are the two credit-scoring models used. The average FICO credit score in the U.S. has remained steady at 716.
While FICO and VantageScore may differ slightly in their criteria, they have the same objective: to help lenders assess the risk involved in lending you money. A high score indicates you've managed your debt well in the past and are likely to repay future debts, resulting in favorable loan terms. A high credit score can unlock lower interest rates, reducing the overall cost of your mortgage. It can also affect the loan amount your lender offers and the requirements for your down payment.
In contrast, a lower credit score may limit your borrowing capacity or necessitate a larger down payment to counteract the lender's perceived risk. If you have a lower credit score, you might have to pay for private mortgage insurance (PMI), adding to your monthly payments. Even with a great credit score, paying less than 20% down may still entail PMI costs, but having a higher score can lead to lower PMI expenses.
Your credit score is calculated based on several key factors related to your financial history, including your:
- Payment History (35%): Records if you've paid past credit accounts on time. Late or missed payments can drag your score down.
- Credit Utilization Ratio (30%): Measures how much of your available credit you're using. The lower your utilization, the better your score.
- Length of Credit History (15%): Considers the duration of your credit accounts, including the oldest, newest and average ages.
- Credit Mix (Types of Credit) (10%): Reflects the variety of credit types you have. A diverse mix is better than only having one credit type.
- New Credit Inquiries (10%): Includes applications for new credit. Frequent inquiries or new accounts can lower your score.
Understanding these factors can help you strategize ways to improve your credit score, making you a more appealing candidate to mortgage lenders.
Credit Score Requirements for Different Types of Mortgages
Not all mortgage loans weigh credit scores equally. Conventional loans, which are not insured by the federal government, tend to have stricter credit score requirements. A lower score might result in significantly higher interest rates, or you might not be approved at all.
On the other hand, government-backed loans, such as FHA loans, VA loans and USDA loans, are often more forgiving when it comes to credit scores. These programs are designed to help more people become homeowners, making them more lenient with credit score requirements. However, even with these programs, a higher credit score typically results in more favorable loan terms.
Understanding the credit score requirements for different types of mortgages can help you evaluate your financing options more comprehensively and allow you to find the type that best aligns with your credit profile and homeownership goals.
The Impact of Low Credit Scores on Mortgages
When it comes to securing a mortgage, a low credit score can shape your mortgage experience in numerous ways, including:
- Higher Interest Rates and Costs: A low credit score often leads to higher mortgage interest rates, resulting in higher monthly payments and a larger total loan cost. Lenders charge more to compensate for the perceived risk of lending to borrowers with a spotty credit history.
- Difficulty in Mortgage Approval: Being green-lighted for a mortgage can be an uphill battle with a low credit score. Lenders may refrain from lending to individuals with poor credit, fearing missed payments or defaults.
- Limited Loan Options: Borrowers with low credit scores may find their loan options limited to certain types of mortgages, such as FHA or other government-backed loans. Conventional loan products might be out of reach until they can improve their scores.
It may not be what many would-be home buyers want to hear, but if your credit score is not in good shape, it can make more financial sense to delay your home purchase until your credit score has improved. — Timothy Manni, Mortgage and Real Estate Consultant
Navigating Mortgages With Less-Than-Perfect Credit
Having a low credit score doesn't mean you can't own a home. However, it does mean that the process of navigating your mortgage might be a bit more complicated.
Improving your score before seeking a mortgage can help simplify the process: below, MoneyGeek explores proven tactics through specific scenarios to help you enhance your credit score before applying for a mortgage. For those unable to improve their scores before seeking a mortgage, we also examined practical strategies for securing a mortgage.
Strategies to Strengthen Your Credit Score
The stronger your credit score is, the more borrowing power you hold. If your credit score is less than ideal, it could limit your mortgage options and lead to a more stressful financial journey. Fortunately, you can improve your credit score in many ways. Here are some scenarios that show you how.
Reducing Credit Utilization
Jake is a young professional with student loans, a car loan, and a few credit cards. His credit score is in the "Fair" category, limiting his mortgage options. Jake decides to make more than the minimum payments on his credit cards to lower his credit utilization ratio. He also sets up automatic payments for all his loans to ensure he never misses a payment.
Diversifying Credit Mix
Maria, a single mom who declared bankruptcy a few years ago, has rebuilt her finances. To strengthen her credit mix, Maria takes out a small personal loan, which she knows she can repay quickly. She also uses a secured credit card, maintaining low balances to showcase responsible credit usage.
Building Credit History
Greg, who recently immigrated to the U.S., has limited credit history. Greg opts for a credit-builder loan. This strategy allows him to demonstrate consistent, timely payments, contributing to a positive payment history.
Limiting New Credit Inquiries
Anna is a retiree planning to downsize to a smaller home. Her credit score is good, but Anna knows reducing her new credit inquiries can help further boost her score. She resists the temptation to open new credit cards, even when lucrative sign-up bonuses come calling. Instead, Anna focuses on managing her existing accounts responsibly.
Correcting Credit Report Errors
Naomi, a mid-career freelancer, always had a handle on her finances. When she decided to buy a home, she was surprised to find her credit score was lower than expected. On checking her credit report, Naomi discovered errors that were dragging her score down. She disputed the inaccuracies and got them corrected, leading to an improvement in her credit score.
While closing out credit cards you're no longer using can be tempting, shedding those accounts can negatively affect your utilization ratio. Keeping them open but not using them for spending signals that even though you have this credit available, you don't need it to manage your daily finances. — Timothy Manni, Mortgage and Real Estate Consultant
Other Mortgage Options for Buyers with Low Credit
Time is often of the essence; sometimes, you don't have the luxury of waiting to build up your credit score before buying a home. In this situation, there are routes to homeownership available, including:
Government Assistance Programs: Instead of minimum credit score requirements, some programs — like VA loans — primarily consider factors like income, employment history and the size of the loan you're seeking.
Subprime Lenders: While these lenders may be more willing to work with low credit scores, they often charge higher interest rates. Borrowers should be cautious, as the risk of falling into a cycle of debt is significantly higher.
Co-Signing Applications: Co-signers with good credit can help you secure loans and rates you might be unable to otherwise. However, they will also shoulder the responsibility for the loan if you default.
Frequently Asked Questions
Navigating the intersection of credit scores and mortgages can be a challenge. We’ve included commonly-asked questions about the topic to help you navigate it.
Your credit score directly influences your mortgage interest rate. A higher score typically leads to a lower interest rate, as lenders see you as a lower risk, while a lower score tends to lead to a higher interest rate.
Credit score requirements vary by lender and loan type, but a score of 620 or higher is commonly needed for most conventional loans.
Yes, obtaining a mortgage with bad credit is possible. Some options include government-assisted programs and enlisting the help of a co-signer.
Your credit score can dictate which mortgage types you qualify for. Some loans, like FHA and VA loans, have more lenient credit score requirements.
Yes, some lenders may consider non-traditional credit histories, like rental and utility payments, for borrowers with limited credit histories.
Typically, multiple inquiries from mortgage lenders within a short period (45 days) count as a single inquiry in your credit report, limiting the impact on your score.
About Christopher Boston
sources
- Fannie Mae. "Confirmation of Conforming Loan Limit Values for 2023." Accessed July 24, 2023.
- FICO. "What Does The Rest of 2023 Have in Store for U.S. Credit Risk and FICO Score Trends." Accessed July 24, 2023.
- Freddie Mac. "Loan Limit Values for 2023 Are Increasing by 12.21%." Accessed July 24, 2023.