How Credit Scores Affect Mortgage Rates

Anyone who’s applied for a mortgage before should be aware that their credit score is an important part of the process. However, it’s easy to underestimate all the ways that your financial history can either help or hurt your chances of securing a loan to buy that dream home. This is why it’s important to educate yourself on the ins and outs of your credit history as well as how that information influences the mortgage process. Here are a few credit factors that you should keep in mind heading into your loan application.

Understand Your Score

First, you should understand what your credit score – also known as your FICO score – is and how it works. Named after a credit model created by the Fair Isaac Corporation, a person’s credit score is supposed to provide a numerical representation of your credit worthiness. It does this using several formulas to translate the details of your credit report into a number.

Your score will generally fall somewhere between 300 on the low end and 850 on the high end. In this case a higher score shows you’ve been responsible, paid bills on time, etc., which makes creditors more confident in your ability to pay your monthly mortgage on time consistently.

Before applying for a mortgage it’s a good idea to find out what your FICO score looks like; preferably many months in advance to allow you enough time to correct any blemishes or errors that you may find on the report.

To do this, you can get in touch with any of the three reporting agencies and ask for your report and score. The agencies – Experian, TransUnion and Equifax – will charge a fee for your score, however they are required to provide one free copy of your credit report once a year. Additionally, you can also get a copy of just your credit report – which shows your payment history as well as any credit balances – for free at any time from a number of other sources; just make sure you check to make sure the site is legitimate before providing any personal information.

Learn the Lender’s Perspective

Since your score provides a historical overview of your financial habits, lenders rely on it because your past behaviors are often a good indication of how you will handle your finances in the future. As such, your score can be a huge influence on whether you are approved for a loan, as well as what kind of mortgage terms they will offer you.

Known as “risk-based pricing,” the idea is to give lenders the ability to adjust the terms of your loan up or down based on the entire risk picture connected with your credit worthiness. Obviously, a higher score – around 700 or higher on average – will generally translate to more favorable interest rates and loan terms.

Additionally, you may even be able to qualify for a reduction in the amount of money the lender requires you to put down initially for your new home depending on how favorable your credit history looks. These perks can vary greatly by lender, so be sure to shop around. On the other hand, it’s important to keep in mind that a lower score – usually in the range of 620 or below – can severely hinder your ability to even qualify for a loan; and if you are able to secure financing, the terms and interest rate may be much less favorable.

Offsetting Other Factors

Aspects in addition to your financial history also play a part in a lender underwriting a mortgage for you. Personal features such as your income level and employment track record are also considered in the course of applying and being approved for a loan. This is where it pays to establish a track record of managing your financial obligations well as a solid credit score can provide creditors some leeway in setting your loan terms.

Exceptional credit history can help offset riskier factors such as a weak job history or help you qualify for a loan amount that’s higher than your income level warrants. So keep in mind that the lender’s decision is a combination of factors; strengths in certain areas can help offset weaknesses in others.

Everyone’s Score Matters

Lenders generally view co-signers on a loan as a less risky prospect because of factors such as increased earning potential that the second party brings. However, this can be a double-edged sword because when there are two people applying for a loan – such as a couple buying their first house – creditors will look at the histories of both parties, and even one bad score could impact the terms. In this case the asset of the additional borrower instead becomes a liability.

This is why it’s a good idea to discuss finances with your partner early and openly in any relationship, especially when any negative details can receive scrutiny in joint applications for important things like mortgages.

Insurance

Most borrowers tend to forget that lenders can require mortgage insurance as a stipulation during the loan approval process depending on the circumstances. Private mortgage insurance (PMI) is generally required when the borrower pays less than 20 percent of the home loan amount up front. This coverage is intended to protect the lender in the event of a default on the mortgage.  When PMI is applied, the insurance underwriters will take the credit history of the applicant into account when determining the premium they will charge for the policy.

While the formula for calculating monthly payments is complex, the main point is that your credit score is one of the components that weighs heavily on the final cost. The standards can vary by insurer, but they are usually fairly inflexible and involve plugging the raw number into the calculation. Although not technically part of the rate of the loan itself, this cost is included in your monthly payment nonetheless and is set aside in a mortgage escrow account by the lender to cover the premium.

The bottom line is that this is yet another cost associated with getting a mortgage that can vary significantly with your credit, which is why it’s a good idea to review your history and address any issues before beginning your mortgage application.