Credit Scores and Their Impact on Home Loans
When home buyers look to get a mortgage, there are a number of factors that can influence financing, including income, assets, and liabilities. However, credit scores — based on credit history — are one of the most important criteria used to determine loan approval.
By reviewing a borrowers’ credit history, a lender can determine how dependable they’ve been in making timely payments on credit cards, car payments and other financed assets. Lenders use this information to get an idea of how dependable a potential home buyer might be in repaying a mortgage. Although credit score is just one of several factors, and there is no magic number for securing a loan, credit score can definitely influence whether a loan is granted and at what interest rate.
What is a Credit Report?
A credit report is a historical record of how and when an individual has paid their bills, how much debt they have, and how long they have had it. Credit reports list things like the payment history on revolving and fixed accounts, any collections activity, bankruptcy filings, car repossessions, etc. It also shows current account balances and credit inquiries by potential lenders.
Three major credit bureaus compile credit reports on U.S. consumers — Experian, Equifax, and TransUnion. Each of these companies formats and reports information slightly differently, so there can be some inconsistencies among them, but they gather the same categories of information.
How to Check Your Credit Report and Score
Every consumer has the right to a free copy of their credit report once every 12 months from each of the three national credit bureaus. These credit reporting companies have set up a central authorized website, toll-free telephone number, and a mailing address through which to order free annual reports:
Under federal law, consumers are entitled to an additional free report if a company takes adverse action against them, such as denying an application for credit, insurance, or employment, based on information in a credit report; if they are unemployed; on welfare; or if a report is inaccurate because of fraud, including identity theft.
Many consumers hesitate to access their credit reports because they have heard that inquiries can have a negative impact on credit scores. However, accessing your own report is never damaging to your score.
Credit reports from the three nationwide credit bureaus contain valuable information, but they do not usually contain credit scores. It takes a little more digging to access these. Home buyers who want to know their numerical scores can:
- Check statements from their financial institution, credit cards or loans. Many financial companies have started providing credit scores for their customers on their statements or online.
- Purchase credit scores from one of the three major credit bureaus or directly from a score provider such as FICO.
- Use a credit score service. Some websites provide a free credit score to users. Others provide scores to customers who pay a monthly subscription fee for credit monitoring.
How Are Credit Scores Calculated?
A credit score is a numerical summary of the information in an individual’s credit report. A long history of on-time payments leads to higher credit scores, which motivates lenders to offer better loan terms. On the other hand, a history of bad financial habits will lower credit scores and make credit more difficult and more expensive to get.
The most commonly used scoring model is issued by the Fair Isaac Corporation. FICO scores, as the scores based on this model are called, range from 300 to 850. The average American consumer has a FICO score around 700.
There are no set uniform standards for how scores are designated; each lender sets its own standards for what a good score is. However, a score of 670-700 or above is generally considered good, with 740 as very good and 800 as excellent. On the lower end of the scale, scores in the 300-579 range can make it difficult to qualify for credit.
FICO scores only look at the information in credit reports that is predictive of future credit performance. Income, employment history, race, religion, national origin, gender, marital status, and age are not considered. The credit data is grouped into five categories, each of which accounts for a percentage of the score: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%) and credit mix (10%).
- Payment history – When borrowers make late payments, their score takes a hit. The more recent, frequent, and severe the lateness, the bigger the hit. Bankruptcies, judgments, and collection accounts have a serious negative impact. Conversely, making payments on time boosts credit score.
- Amounts owed – Carrying large balances on personal loans and revolving debt, like credit cards, particularly if those balances are close to the credit limits, lowers scores.
- Length of credit history – The longer a borrower’s credit history, the better.
- New credit – This factor looks at the number and proportion of recently opened accounts and number of inquiries. While multiple inquiries can lower scores, all mortgage or auto loan inquiries that occur within a short period of time are considered just one inquiry for scoring purposes. Accessing your own report is not damaging nor are inquiries for pre-qualification offers.
- Types of credit used – Having a variety of accounts, such as credit cards, retail accounts, and loans, boosts scores because it demonstrates borrowers are capable of handling the responsibilities that come with each debt type.
How Do I Improve My Credit Score?
If prospective home buyers are worried about their credit score or interested in qualifying for better rates, there are specific ways to improve a credit score, based on the factors above:
- Payment history — Pay bills on time. Some credit bureaus enable consumers to opt into programs to add bills into their payment history that aren’t usually tracked, like utilities and cell phone bills.
- Amounts owed — Pay off debt early, if there is no prepayment penalty. Pay revolving credit card balances down to less than 30% of the maximum limits.
- Length of credit history — Don’t close old credit card accounts, even if they aren’t in use. They are valuable history.
- New credit — Consumers thinking about buying a new home should avoid opening other credit accounts or taking on other major debt, such as a new car loan, right before applying for a mortgage.
- Types of credit used — Be sure to have both installment accounts (with equal payments for a set time, like a car loan) and revolving credit (with flexible payments, as with credit cards).
The other important way home buyers can boost their credit scores is by disputing any errors in their credit reports. This happens more often than people realize. That’s why it’s important for prospective home buyers to look at their reports before their lender does and take steps to get errors removed.
Credit Scores and Getting a Mortgage
While there is no uniform standard for what constitutes a “good” credit score, many mortgage lenders look for a score of at least 680 for approval and mid-700s for the best interest rate. Home buyers with scores in this range, or who can raise them to this level, are probably in good shape.
However, there are options for would-be borrowers with lower credit scores:
- FHA (Federal Housing Administration)-backed loans will accept credit scores as low as 580 with the minimum down payment of 3.5 percent and are accessible to homebuyers with scores lower than 580 who put down 10 percent or more of the home price at closing. Also, people with lower credit scores don’t necessarily pay higher interest rates on FHA loans.
- VA loans for active military and veterans also do not require higher interest rates for borrowers with lower credit ratings, and the VA (Veteran’s Administration) doesn’t set a minimum credit score requirement. However, most VA lenders will set their own minimum score, generally between 580 and 620.
- There are also programs for entry level buyers from USDA, Fannie Mae, and Freddie Mac that have lower credit score entry points than conventional mortgages.
- Home buyers with substantial down payments may have a better chance of qualifying for a conventional mortgage in spite of low credit scores.
Borrowing With Bethpage Federal Credit Union
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