Besides having a down payment, your credit score is probably the most important factor for a mortgage. Much like saving a down payment, it can also take some time to restore your credit score if you need it or improve it to get a better interest rate which translates into a lower monthly mortgage payment.
With home prices as high as they are today and interest rates hovering between 5.5% and 6.3%, managing your credit score is critically important to both you qualify for a mortgage and to be able to pay the monthly installments.
Not only do you need at least a minimum credit score to qualify for a mortgage, but the interest rate you’ll pay is also largely determined by the level of your credit score. For most mortgages, the minimum credit score needed to buy a home 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 rare. A higher score greatly improves your chances of approval. Borrowers with a score below 650 represent only a small number of buyers who end up buying a home. From all angles, the more you can raise your credit score, the better off you will be before locking up a mortgage.
For example, a A $350,000 30-year mortgage at 6.3% will have a monthly payment of $2,166 (without property taxes or insurance). This same loan of $350,000 at 5.5% will have a monthly payment of $1,987. The monthly difference of $179 may seem small at first glance, but it can make a substantial difference. From a debt to income perspective of a lender, this amount doubles because your monthly debt increases by $179 and your monthly disposable income decreases by the same amount. From your personal financial perspective, that means you have $2,148 less to spend each year.
Different lenders have slightly different criteria for assigning interest rates to credit scores. Typically, the range looks like this:
- 800 or more – Excellent
- 740-799 – Very good
- 670-739 – Good
- 580-669 – Just
- 579 or less – Poor
An example of interest rates for different scores would be something like a score between 660 and 679 given an interest rate of 5.36%. A score between 620 and 639 is assigned an interest rate of 6.34%. If your score is on the edge of these general ranges, it’s worth looking 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 good shape, but you might be wondering how to get 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 of 300 to 850. Trying to get a perfect score is nearly impossible and probably not worth the effort. However, striving for a score in the 780-800+ range can be worth the effort.
These tips assume you’ve already done what’s necessary to bring your score up to at least 690 or 700, which means you don’t have bankruptcy, you’ve cleaned up any mistakes on your credit report, etc.
Tip #1. Always pay on time. Still. With a score already correct, this is the most influential factor to improve it even more. On your credit report, late payments are called “delinquencies.” They remain on your report for 7 years, but the older they are, the less they count towards your current score. Most have little impact after 2 years. Remember that everything on your credit report is automated, so even a day late will cause the payment to be overdue. This can be a good reason to use automated payments if you’re not always quick to pay 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. Do not close old accounts. These can show that you have been a responsible borrower for longer. Having the balance available also helps your credit utilization rate (see below). In most cases, having older accounts (including unused ones) on your report will increase 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 with the credit ratio is to stay below 30% utilization. This means that if your limit is $10,000, your balance should be around $3,000. You can improve this by wisely increasing the limit or, more wisely, decreasing the amount you owe.
Tip #4. Continue to monitor your credit score for errors. You’d be surprised at the number and frequency of errors reported in people’s credit reports. At a minimum, pull your free annual report from every major reporting agency. If you have to pay for an up-to-date copy shortly before applying for a mortgage, it may be worth the little extra. Do this about three months before applying for a mortgage, as it takes time for errors to clear.
Tip #5. Establish a good mix of credit types. This is a good indication to lenders that you are one of the most responsible borrowers. Not all types of credit are the same when calculating your credit score. Common types of credit include unsecured credit cards, secured auto loans, and personal loans. Store credit cards are on the low end, and needing a co-signer is even less desirable. But… you need to have credit to improve your credit score. If you’ve paid off all your debts, good for you. However, you may want to consider opening a credit account to keep your score up to date. This could be taking out a low-interest loan that you know you can pay back on time, every time. Maybe instead of paying everything in cash for a car, make a big down payment and take out a small loan. Or a credit card on which you can make a small charge each month and keep the ratio of the amount borrowed at the limit close to 30%.
Ultimately, on-time payments and your credit ratio tend to have the most impact when trying to improve your good credit score to great.
What is your advice for improving a good to excellent credit score? Please leave your comment.
Additionally, our weekly Ask Brian column welcomes questions from readers of all levels of experience with residential real estate. Please send your questions, inquiries or story ideas to [email protected].