Have you checked your credit score lately? If you’re thinking about buying a home and you don’t know what your credit score is, it may be a good idea to find out. Your credit score can have a significant impact on your mortgage rate and your ability to build equity in your home. That’s why working to improve your credit score before applying for a loan may be one of the most important steps you can take to financially prepare to buy a home.
Read on to learn more about how your credit score affects your mortgage rate, what a good credit score is, and what you can do to improve your credit score over time.
What Is a Credit Score?
Let’s begin with the basics by defining what your credit score is. Your credit score is a number used to rate your credit risk; that is, how likely you are to pay back a loan on time. It is calculated using information from your credit report, which includes:
- Your bill payment history
- Your current loans and debts
- The proportion of your available credit that you are currently using
- Your credit history, including any defaults on loans, bankruptcies, or foreclosures
Basically, your credit score is a reflection of your history of making on-time payments to creditors. Lenders use it to determine the level of risk they are taking on by lending you money.
Why Does Your Credit Score Affect Your Mortgage Rate?
From a lender’s perspective, a mortgage is risky business. When a lender provides a mortgage, they are typically lending out hundreds of thousands of dollars to be paid out over a long period of time, typically 30 years. They know that during this time, a borrower is likely to experience ups and downs in economic cycles as well as personal struggles, job losses, and periods of uncertainty. To give them an idea of how likely a borrower is to repay their mortgage and how much risk they are taking on, lenders use credit scores to qualify borrowers for mortgages and determine what interest rate they should pay.
A borrower with a high credit score has a history of making on-time payments to creditors and therefore presents less risk to the mortgage company than a borrower with a lower credit score. To compensate for the increased risk they take on when they loan money to a borrower with a low credit score, a lender charges them a higher mortgage rate.
While it is possible to obtain a mortgage with a low credit score, you will likely have access to better interest rates with a higher credit score. As you will see in the example below, a difference of just 100 points in your credit score could save you a significant amount on your monthly repayments, and this can add up to thousands of dollars over the life of your loan.
How a Higher Credit Score Can Save You Money and Help You Build Equity in Your Home
To illustrate the impact of your credit score on the cost of your loan, consider this hypothetical example:
Let’s say you’re looking to buy a home worth $500,000, and you have a 5 percent downpayment saved up. You apply for a 30-year fixed-rate loan for the remaining $475,000. With a credit score of 680, you are offered a 30-year loan at a 4.5 percent interest rate, which translates to monthly payments of around $2,407.
Let’s say, instead, that you work on increasing your credit score to 780 before applying for a loan. You are then able to get a 30-year fixed-rate loan at a rate of 4 percent, which translates to monthly payments of $2,268, $139 less per month than if you had taken out a mortgage at the 4.5 percent rate.
In considering the above, it’s important to keep in mind that in addition to creating higher monthly repayments on your loan, a higher interest rate also means you are paying off less principal early on in the loan period. This means that those who obtain a lower interest rate as a result of having a high credit score are able to build equity in their home faster than those with lower credit scores.
What Is a Good Credit Score?
Credit scores can range from 300 to 850. Every financial institution has its own set of standards for qualifying borrowers and determining mortgage rates. In general, however, credit scores can be classified as follows:
800 - 850: Excellent credit
740 - 799: Very good credit
670 - 739: Good credit
580 - 669: Fair credit
300 - 579: Poor credit
Most lenders require a borrower to have a minimum credit score of 620 to be offered a loan. Those borrowers with good credit and above (credit scores of 670 and higher) are typically viewed as acceptable or low-risk by lenders and are offered the best rates. Some lenders have more stringent requirements or may offer an even better rate to those borrowers with very good or excellent credit scores (740 and above).
Options for Home Buyers With Lower Credit Scores
With conventional loans, a borrower’s credit score is the key determinant of the mortgage rate. Government-backed loans, on the other hand, place less emphasis on a borrower’s credit score in determining mortgage rates. Therefore, they are a good option for new home buyers with lower credit scores. FHA loans accept borrowers with credit scores as low as 500, and USDA loans typically require a minimum credit score of 640. It’s important to realize, however, that these types of loans have specific regulations attached to them. FHA loans come with higher upfront and annual costs due to their requirement for mortgage insurance. USDA loans place limits on borrowers’ income levels and only apply to homes in eligible rural areas.
Credit Score Requirements for Construction Loans
Most new homebuyers obtain a traditional mortgage to buy a move-in-ready or semi-custom new construction home. If you’re thinking about building a custom home, however, you will need a construction loan to cover the costs of building. Construction loans typically have more stringent credit score requirements than other types of mortgages. This is because the loan cannot be secured by an actual building in the same way that other types of mortgages can. Lenders typically require a minimum credit score of 680 for a construction loan and some even set the minimum credit score at 720. Lenders also require that they are able to review architectural plans for the home, as well as the construction timeline and budget before approving a construction loan.
An FHA construction loan is an alternative for those who wish to build a custom home but do not qualify for a conventional construction loan. An FHA construction loan is very similar to any other type of FHA mortgage and requires a minimum credit score of only 500.
How To Find Out What Your Credit Score Is
There are two ways you can find out what your credit score is:
- Through your bank or credit card company - Check your statements or online accounts to find out your credit score for free.
- Obtain a copy of your credit report - By law, you are entitled to a free copy of your credit report each year from the three major credit reporting agencies, Experian, Equifax, and TransUnion. Visit AnnualCreditReport.com to obtain your free reports. Not only is it a good idea to use your credit report to find out your credit score, but you should also carefully review it each year to check for any errors that may be affecting your credit.
How to Improve Your Credit Score
There are several steps you can take to improve your credit score. These include:
- Paying all your bills on time - The most basic thing you can do to improve your credit score is to pay all your bills on time. This includes everything from rent and loan repayments to credit card, utility, and medical bills.
- Cap your spending - Maintain a balance of less than 30 percent of your available credit to avoid hurting your credit score.
- Pay down credit cards - If you have any credit cards with a balance of more than 30 percent of their available credit, work towards paying them down as soon as possible.
- Avoid opening or closing credit card accounts - If you are actively trying to improve your credit score in anticipation of applying for a mortgage, it’s best to avoid opening or closing credit card accounts since this can hurt your credit score.
- Check your credit reports and correct any errors immediately - It is not uncommon for people to find errors on their credit report, and these can have a significant negative impact on your credit score.
- Apply for mortgages within a 30-day period - Mortgage applications require a hard credit pull. Multiple hard credit pulls in a short timeframe will not impact your credit score as much as credit inquiries that are spread out over a longer period.
- Consider working with a credit counselor or lender - If your credit score is very low or you need to build significant credit before you are eligible to apply for a loan, you may want to consider working with a credit counselor or lender who can advise you on specific strategies for improving your credit in your unique circumstances.
NewHomesMate Is Here to Help
Working to improve your credit score is one of the most important steps you can take toward financially preparing to buy a new home. When you’re ready to start exploring the new construction market, NewHomesMate is here to assist. On our platform, you can search for and tour thousands of new construction homes and communities in your area, and we can even help you get pre-approved for a mortgage! Learn more about us and start searching for your new home with NewHomesMate today!