When you apply for a mortgage, one of the first things the lender will do is check your credit score. Your credit score is essentially your financial reputation. Lenders use your credit score to gauge how likely you are to repay the loan.
What Kind of Risk Do You Represent?
Since your credit score is numeric representation of your credit history, it’s considered an indication of the kind of risk you represent. If you have a low credit score, it is an indication that you have had trouble meeting your debt obligations in the past. A low score might also mean that you don’t have enough of a credit history to make a determination of how reliable you are likely to be.
In either case, lenders might think that you present a larger risk of default. They might take steps, like demanding a minimum credit score for mortgage programs, to ensure that your unreliable financial past doesn’t harm the bottom line too much. After all, lenders are in business to make money.
The first way your credit score affects your mortgage is in whether or not you are approved for the home loan. After the financial crisis of 2008, many mortgage lenders stopped considering anyone with a score of below 660. There are a few conventional lenders that will approve a loan for someone with a score of 620, but it’s rare to find a lender willing to take a chance on someone with poor credit.
It’s possible to get approval for a FHA loan with a credit score as low as 580, but there are some hoops to jump through, and you will have to pay for your poor score with a higher interest rate.
Your Credit Score and Mortgage Rates
Once the lender decides that your credit score is adequate for a loan, it plays its next role: Acting as the main factor in determining what your mortgage rate will be. Since a lower mortgage credit score means a bigger risk of default, your lender will charge a higher interest rate in order to help offset some of the risk. Remember that when you buy a home with a mortgage, it’s actually the lender that has put up the capital; you are repaying that loan. If you have a poor credit score, the lender is taking on a bigger risk that you will default — and the lender will lose some of that money.
Your credit score can have a big impact on how much you pay over the course of your mortgage. Since the interest rate determines the fee you are charged for borrowing, even a 1 percent difference can add up over the course of a 30-year loan. Consider a home that costs $200,000 with a down payment of $20,000. You borrow $180,000 for 30 years.
If you have good credit, you can get an interest rate of 4.25 percent. By the time you pay off your home, your total interest paid will be $138,777.05. On top of that you will have a monthly payment of $885.49. That’s not bad.
Now, what if your interest rate was just one point higher, at 5.25 percent? First of all, your monthly payment will be a little more than $100 higher, at $993.97. That affects your monthly cash flow, just because your credit wasn’t as good. The cumulative effect is even bigger. At the end of your 30-year mortgage term, you will have paid $177,828.00. That’s a difference of almost $40,000 — and the big factor was that your credit score wasn’t higher.
Before you apply for a mortgage, consider you credit situation, and take some steps to boost your score. You’ll have a better chance of getting approved, and you’ll save tens of thousands of dollars.