It is always a good idea to know what your credit scores are, and there are multiple reasons for this. Knowing your credit score comes in handy for everything from auto loans, qualifying for any credit cards, renting a home or apartment, and even getting utility services can be affected by what your credit scores are.
This is no different when it comes to purchasing a home, and you need to know your credit score as a first step toward your process of owning a home.
Knowing what your credit score is will help you in determining what the interest rate as well as other costs will be that you will need to pay on a mortgage loan.
A higher credit score will show a lender that you have been paying bills from credit cards or other loans on time and that you haven’t been maxing out your credit cards, etc. This will help a lender to see that you pay your payments on a loan on time and with consistency. This will allow you to be seen as an investment that is considered to be low-risk and it will allow lenders to offer a lower interest rate as well as lower costs for other aspects of your loan.
Lower credit scores cause a lender to see you as an investment that is considered to be risky. If the lender decides to approve you despite your lower score, they will charge a higher interest rate to you as an exchange for the lender giving you the loan which is perceived as risky to do.
How Does A Lender View Your Credit Score?
A credit score is a number that is a representation of where your credit profile presently stands. Depending on what credit model you are looking at, you may notice a slight difference in your credit scores, but each model is based on specific factors which look at how you have used and currently use credit, loans, credit cards, etc.
Think about it this way, imagine a friend of yours asks you if they can borrow some money. Now assuming that you have the funds to give them the loan, you may be wondering questions such as, when was the last time he borrowed money, did they pay me back that time? Did they pay back the full amount to me? Was this done in the timeframe they promised to do so?
If all of these questions were answered with a yes, then likely, you will loan the money to that friend. However, if any of these questions were answered with a no, you might be more hesitant to loan them the money, not do so at all, or only do so with specific conditions put into place.
Now, taking what we just said and applying it to lenders, such as mortgage lenders, a good or excellent credit score would be the same as the answers all being yes, and would show the individual applying’s ability as well as the likelihood that they will be able to consistently pay their home loan on time.
A poor or low credit score report is the same as someone answering no to some or all of the questions we mentioned above. In these instances the lender might not want to loan the money to you, or might only be willing to loan to you with specific safeguards and conditions being in place.
Before the housing market crash in 2007-2008, those individuals that had poor credit had an easier time being able to find subprime loans. There were not as many heavy regulations on lenders as there is today. Obama, in 2010, signed the Dodd-Frank Wall Street reform and made it legal. This law made tighter requirements for the mortgage industry and made qualifying for a loan become more difficult, especially for those that have lower credit scores.
What Type of Credit Score Will Be Needed To Purchase a Home?
The majority of lenders have a credit score baseline that they will use in order to deny or approve applicants for mortgages. A credit score that is in the 700s or higher is considered to be an excellent score and will likely allow you to get a loan that offers a lower interest rate.
After a credit score drops lower and into the 600s you start being seen by lenders as a potential risk to lend to. For example, a person who has a credit score that is 680, is still in the green and considered good, however scores that are below 660 is when some lenders will start to turn you down. There are other lenders that between 620 and 640 is where a better mortgage loan program is taken off the table. This completely depends on the lender themselves and what the qualifications they require are.
The scores and points for cut-off are for the conventional mortgages that are fixed-rate, and there are still other types of mortgages that are available, for example, VA or FHA, that are more simple to get and have been designed for a borrower that has a credit score as low as 500.
Some examples of minimum FICO scores required based on the type of mortgage are:
Conventional Loan – credit score of 620+
VA Loan – credit score of 620+ (there are some lenders that only require 580)
USDA Loan – credit score of 640+
FHA 203K Loan – credit score of 620+
FHA Loan – credit score of 580+ (a score of 500-579 is possible but is not very likely)
Can An Individual Buy A Home With Bad Credit?
After your credit has dropped below the 500s, this makes you a candidate for a bad credit home loan, which is also known to the industry as a subprime loan. A subprime loan have a interest rate which is a few percentage points higher than what is offered to those with higher credit scores, who are also known as prime borrowers. A subprime loan also may come with additional costs and fees.
One example of this is, for those that have a lower credit score, they are likely to pay an interest rate that is 0.375% higher than the average mortgage a person with a credit score of 700 or higher will get with a 30-year fixed-rate mortgage. So, say that the 30-year primary mortgage rate is 3.875%, that would mean a person that only has good credit, not excellent would have to pay 4.125%, which is .25% higher than the primary rate, and a person with bad credit would pay 4.5%.
This would mean that the monthly payment amount would be approximately $82.99 more than the prime borrowers every month, and $29,876.40 more over the period of 30 years, which is considered to be the life of the loan. Not to mention, if you are unable to make a down payment of twenty percent, then the lender will want to have you pay a PMI premium, or private mortgage insurance premium, that could be up to 110% of the loan’s total amount each year, and it is comparably a lot higher than what the premium would be for a person who has good credit.
The answer is technically yes, you will possibly be able to purchase a home with a conventional fixed-rate mortgage with bad credit, but it will have additional fees and a higher interest rate. A bad credit score will ultimately cost you more money both monthly and over the lifespan of the loan.
Then, what can be done to help your credit?
How You Can Improve Bad Credit
A credit score will not haunt you for life, as it isn’t set in stone. Just because you have a bad credit score, doesn’t mean you always will. There are several ways that you can go about improving your credit score and creditworthiness.
The first step you need to take before you apply for a mortgage loan is to take a look at your FICO score. There are some reputable websites that will offer all three of your credit reports at absolutely no cost to you. Some of these companies even offer an app that will alert you if there are any changes to your credit profile. Sites such as Wallethub, Credit Karma, Sesame Credit, and Credit.com all offer free credit score reports that offer options to help you improve your credit in the major areas that make up your credit score.
If you take a look at all your habits financially and look into ways that you can improve, for example, are there ways that you can improve paying your bills on time, or can you limit the amount of hard inquiries that are made against your credit?
Or maybe you have the ability to pay down some of the debt or review your reports for accuracy and dispute any errors if there are some.
FHA Loans: Are They An Option?
The Federal Housing Administration backs FHA loans. The FHA does not issue the loans personally, but can insure them in situations where the borrower defaults on the loan. This will reduce the risk for the lender and allow them to lower the credit score that is needed in order to buy a home.
When you know that your credit scores will affect your ability for getting a conventional mortgage in a negative way, or could affect your rate, you may have the option of a FHA home loan. An FHA loan has underwriting standards that are much easier for buyers that have lower credit scores, smaller down payment amounts, or both of these.
500 or higher is the lowest FICO credit score that an individual can have for a FHA loan. If you have a score of 580 or higher, then you will need a down payment of at least 3.5%. If you have a credit score between 500-580, you are still able to be approved for an FHA loan, but you will need a down payment that is larger than 3.5%, which will have to be at least ten percent.
It is rare, however, to get approved for FHA loans when you have a credit score that is lower than 580.
A Lender Doesn’t Just Look At Your Credit Score
The borrowers ability to pay back a mortgage is becoming easier for a mortgage lender to discover due to doing more than just looking at the credit score of a borrower. One of the aspects that will help you is having credit that has been re-established, this could be due to an economic event causing the bad credit but you have since recovered from this hardship financially.
A lender will also take a look at the amount of debt that you have, and if you do not have much debt, then this will be a compensating factor that is strong for bad credit. A compensating factor is a factor that will lower the risk to the lender, which will allow them to lend to a borrower that has a lower credit score. A mortgage company likes to see recent history of payments that are solid and have no collection amounts or late payments within the last 12 months.
There are several different compensating factors that help with bad credit for an individual that is applying for a loan.
These compensating factors are:
Income that is high
Ratio of debt-to-income that is low
Ratio of loan-to-value that is low (Meaning high down payment of at least ten percent)
Substantial amount of money in savings
Employment history with current employer is long
Ranges For An Individual’s Credit Score
In the United States, there are three major reporting agencies for credit, which are Experian, TransUnion, and Equifax. All three of these bureaus will grade your credit history on a range from between 350-850.
It is not uncommon for the three different bureaus to have a different number due to the fact that not all creditors will report to all of the companies. A score of 700 is considered to be good by most lending companies, a poor score is generally considered to be anything that is below 620.
Below you can see the breakdown of credit scores:
350-579 is considered to be bad credit.
580-619 is considered to be poor credit.
680-739 is considered to be average credit.
740 and above is considered to be great credit.
Additional Tips For House Buying
So, you are currently in the process of finding a lender and getting prequalified to get a mortgage loan. The good news is there are several things that you can do to get started with this process on the right foot.
Pay Down Your Credit Card Balances
The credit utilization ratio is what the percentage of credit that a person is using on the credit card accounts. Thirty percent of your credit score is accounted for by credit utilization ratios.
The higher that the balance on your credit cards is, the lower that your credit score will be. It is important that you pay down your credit card balances as low as you can before you apply for a mortgage.This will help you to have a higher score and a better chance of being accepted by the mortgage lender.
“Pay for Delete”
There is an option with some collection accounts on your credit report that have an obvious negative impact on your credit score. You can reach out to these collection agencies directly to ask if they would be willing to do a pay for delete.
What is a pay for delete? It is an agreement that an individual will pay the balance owed and in return the creditor will remove this account from that individual’s credit report. If a creditor does not agree to do this, then there is not any reason to pay off collections, unless you have been told to do so by the lender. Simply paying off collection accounts does not improve a person’s credit score.
Become an Authorized User
If a close friend or family member has a credit card, you can ask if they would be willing to add you as an authorized user onto their account. This will allow the entire credit history of that account to be added to your credit report.
FICO includes authorized user accounts in the algorithm for credit scoring. This can be a quick and simple way to add at least 30 points to your FICO score.
Consider Using a Co-Signer for the Loan
If you want to have access to decent mortgage rates but your credit is bad, you can try adding a co-signer.
A co-signer will allow for a borrower that has a poor credit score or inadequate credit history to be able to increase their chances of being approved for a loan.
Find Out Where Your Credit Stands
The interest rates being higher this year can make a difference for affordability. Even half a percent can make or break a person’s budget. That is why your credit score is so important when buying a home.
We hope this article has helped you become more informed on what kind of credit score you will need in order to get a home loan.
