Most people have heard that your credit is essential when getting a mortgage and buying a home, but exactly how your credit impacts your mortgage is much more of a mystery. Today, we will break down a few of the most important ways your credit can affect your mortgage.
Before we dive in, we need to get a few definitions out of the way. When we talk about credit, we mean two things: your credit history and your credit score. Your credit history is a record of your creditworthiness, including things like if you make payments on time, if you have had a bankruptcy recently, or if you failed to make a utility payment. Credit bureaus use your credit history to generate your credit score, which is a number that represents your creditworthiness. Usually, this is on a scale from 300 to 850. If you want to learn more about how credit scores work, check out these articles from Experian here and here.
With those definitions in mind, let's learn some of the most significant ways your credit impacts your mortgage!
Qualifying For A Mortgage
The first way your credit impacts your mortgage is that it helps decide if and what type of mortgage you qualify for. Different types of mortgages are referred to as "Loan Programs". Each program has different criteria you have to hit to qualify, and both your credit score and history are almost always part of them.
Many loan programs have a minimum credit score to qualify for them. For example, at the time of writing this article, FHA loans generally require you to have a 580 credit score or higher to be eligible for them. Some lenders who provide FHA loans can require even higher scores (this is called a "lender overlay", as they lay their own rules over those provided by the FHA). If you don't have a credit score over this minimum, you typically cannot qualify for that mortgage type.
Even within a loan program, your credit score can change the qualifications you get. As an example, for FHA loans, the higher your credit score is, the higher they allow your debt-to-income ratio to go, potentially helping you qualify for the program with higher debt, lower income, or a larger loan. Read our post here if you want to learn more about debt-to-income and how your credit impacts it.
Loan programs don't just look at your score. Even if your credit score is above their minimum, the specifics of your credit history can also prevent you from qualifying for a mortgage. So, if you have a credit score over 580 but you have two or more 90 day late payments on a credit card, you may have trouble qualifying for an FHA loan.
If your credit score is too low or you have issues in your credit history that disqualify you from programs, you may not be able to get a "conventional" mortgage like an FHA or Fannie Mae-backed loan. In this case, you may have to go to a specialized lender who does "non-qualified" mortgages that eschew some of these requirements. Be careful though, you may end up paying a much higher interest rate, get into odd and unfavorable loan terms, or pay hefty fees to get these types of loans. Generally, working on your credit first and putting off buying a home will help you get better and more sustainable loan terms.
Your Interest Rate
The second major way your credit impacts your mortgage is in helping to determine your interest rate. Generally, the higher your credit score, the lower your interest rate will be. However, there are a lot of specifics to be watchful of!
Interest rates for mortgages are set by many factors, including how much you put down on your new home and the loan program you are using. That said, your credit score is a significant factor in determining your rate. Most lenders use credit score "bands" to determine your interest rate. These "bands" are ranges of credit scores that all get the same base interest rate and are usually about 20 points wide. A lender may have a "band" of 620-639 with an interest rate of 3%, meaning if your credit score is 620, 639, or anything in between, you will get a 3% interest rate.
Because lenders use these bands, your exact credit score becomes very important. To illustrate this, imagine a lender has a 620-640 credit band with a 2% interest rate and a 640-660 credit band with a 3% interest rate. In this case, if you had a 639 credit score, you could improve it by a single point to get huge savings. On the other hand, if you had a 620 credit score, improving it even by 10 or 15 points would have no impact on your interest rate. Because of this, it is important to know both your exact credit score and where you fall within these bands before thinking about how much you need to improve your credit score.
While generally having a higher credit score means you get a lower rate, there is usually a cap. Once you have a credit score over 740, many lenders will not give you a lower rate for a higher score. While improving your credit is always good, this means you don't need to wait to have a perfect credit score to get access to some of the best mortgage interest rates!
Finally, credit history is usually not considered as much in setting your interest rate. As long as you qualify for the program, your credit score will be the more significant factor determining your rate.
How Much You Pay For Mortgage Insurance
The third biggest way your credit can impact your mortgage is how much you have to pay for mortgage insurance. Mortgage insurance and your credit work very similarly to how your rate works with your credit: your credit history doesn't have too much of an impact, the higher your credit, the better, and rates are usually set with bands. That said, there are some key differences with mortgage insurance.
While everyone has an interest rate on their mortgage, you only need to get mortgage insurance if you put less than 20% down on a home. Even if you have a lower credit score, if your downpayment is large enough, you can avoid having to pay mortgage insurance at all. However, if you put less down, you may have to pay mortgage insurance every month, and the amount is based on many factors, including your credit score.
Similar to interest rates, the lower your credit score, the more you typically have to pay for mortgage insurance. This is usually applied as a "mortgage insurance price adjustment" - a fancy way of saying "make it more expensive if they have a lower credit score." Beware: these "adjustments" can be huge. On a recent mortgage insurance rate table from MGIC, a leading mortgage insurance company, borrowers in the 620-639 credit score band paid as much as 3x more per month for their insurance compared to those with a 760+ credit score. On a $300,000 mortgage, that's a difference of almost $4,000 a year!
There are a few other major differences in how mortgage insurance works compared to your interest rate. First, once you have paid enough on your mortgage, you can typically refinance your loan and get rid of the monthly mortgage insurance payments, even if your credit hasn't changed. Second, there are some loans where your credit does not impact your mortgage insurance as much, the biggest being FHA loans. FHA loans generally set their mortgage insurance rates based on how much you put down, irrespective of your credit. Making them potentially better options for those with lower credit scores.
Wrapping It All Up
As you can see, your credit is a major factor in some of the most important parts of your mortgage. From determining how much interest you pay to the loans you qualify for, credit is essential.
But as you can see, there is a lot that goes into calculating each of these components, something that most mortgage calculators miss.
That's why we built Quo. Quo is a mobile app that does all of the work to figure out exactly what you should do to become a homeowner. It uses real guidelines straight from loan programs to figure out the ones that are best for you, shows you if and how much you could save by increasing your credit score, and does the math for you to find the optimal path to buying a home. Plus, once you are ready to buy, it can connect you with your own home coach to help you get a loan!
Best of all? Quo is free to use! Check it out on the app store here.