How Will My Credit Affect My Mortgage Options?
Have you ever wondered about how your credit history will affect your mortgage options? The truth of the matter is that having a poor credit score can lead to significant financial difficulties when it comes time to purchase a new home through a lender.
This typically involves both your current credit score and your credit history:
- If you have a poor credit score, chances are your credit history is also in disarray
- If you have a decent credit score, and managed to pay off some debt, but have some marks against your credit from outstanding debts, this will negatively impact the decision from the lender
Of course, it is not impossible to purchase a home with a low credit score - it just will be more expensive. In this article, we will take a look at how your credit rating will affect your mortgage options and related costs affect your financial future.
How Your Credit Affects Your Mortgage
To start, your credit score and history directly affects the follow aspects of your loan:
- The amount you can borrow from a lender
- The types of mortgages you can receive approval for
- The interest rates you’ll pay over the duration of the loan
- How much you’ll pay for private mortgage insurance (PMI)
Simply put, the higher credit score, the better the terms of your mortgage.
For conventional financing, you’ll need a credit score of at least 620 in order to be eligible for most loans. As your credit score increases, this means that you will be a less risky investment for lenders and won’t have to be subject to more stringent requirements set for those with poor credit.
Price Comparison Based on Credit Score
In the eyes of lenders, there is a significant difference between a 620 credit score (a fair score) and a 750 score (very good). For the lower scores, you could end up paying a slightly higher percentage rate for the same mortgage. At first glance, a slight difference might not seem significant in light of a 30-year mortgage. However, when you do the math, these slight differences add up.
- For a $200,000 home mortgage at 3.625% interest for a 750 credit score, that results in a monthly payment of $912.
- For that same home mortgage at 4.125% interest for a 620 score, your monthly payment will be $969.
The difference may seem small at just $57/mo more for a lower credit score. However, for that 30-year term mortgage (with 360 payments over the course of the loan), this translates to $20,520 extra that you wouldn’t have had to pay if you had a higher credit score.
Credit history can affect your loan-to-value ratio (LTV)
The amount you are allowed to borrow is also tied to your credit score. Referred to as “loan-to-value ratio” (LTV), this represents a percentage of a home’s value that borrowers are able to borrow up to. The better your credit score, the higher the percentage you can qualify for - and the less that you will need to shell out for a downpayment.
For example, if you quality for a 95% LTV on a home appraised at $200,000, you can receive a loan for $190,000 and will have to provide a down payment to cover the remaining $10,000 (5% of the mortgage). Those with lower credit scores may only qualify for 80%, which puts the remaining 20% as a significant down payment at $40,000.
Low credit may exclude you from certain loan programs
If you have a bad credit history, lenders may be reluctant to help you finance a house with certain loan programs. With conventional financing through Freddie Mac and Fannie Mae loans, you typically won’t receive assistance if your credit score is below 620. Non-agency lenders - meaning private institutions - can set their own rules and use their own judgement on granting you into their loan programs, but this is usually evaluated on a case-by-case basis (ex. you have a significant lump-sum from an inheritance/windfall).
Credit scores determine underwriting terms
When a lender underwrites your loan, they are performing a risk-assessment for what is required in the terms of the loan. If you have poor credit, the lender may scrutinize your entire finances, including income, length of employment, cash reserves, and how much you can afford in down payment. They are more likely to strictly follow the published requirements for those with poor sores.
On the other hand, if you have a better credit history, lenders may be willing to overlook certain factors that would normally be red flags for those with lower credit. For example, if you’ve just moved to a new area and just started employment with a new company, a lender may look at how much you’ve saved before casting a judgement on whether you are a risk.
Credit scores can also affect private mortgage insurance (PMI)
As one of the seldom-discussed parts of a mortgage, private mortgage insurance (PMI) is required by lenders to insure the mortgage in the event that you default on the loan. PMI is generally required for those who put down less than 20% of the purchase price for a down payment regardless of credit score; however, PMI companies take credit history into account when calculating the cost of that insurance.
Because PMI is required as protection for your remaining balance on the mortgage until you reach 80% equity for the home, you will end up paying a percentage that’s added to your monthly mortgage payment.
For example, suppose you have a $200,000 mortgage. With a credit score of 750 or greater may qualify for PMI at a rate of .6%. This means that you will pay $1,200 more a year (or $100 per month) for your mortgage payments. But if your credit score is 679 or less, you may be required to pay 1% a year. This works out to $2,000 annually tacked on to your mortgage yearly - nearly twice the amount than those with better credit.