If you’re thinking about purchasing a home, one of the top things on your mind is probably getting the best mortgage rates. While it’s important to save up for a down payment and shop around for quotes from different lenders, there’s something even more critical that can impact your mortgage rates: your credit score. Having a credit score that meets the minimum requirements to qualify for a mortgage may not be enough to get you the most favorable rates. In fact, a “good enough” credit score could end up costing you thousands more in interest over the life of your loan. Before you start the process of applying for a mortgage, it’s essential to understand how your credit score impacts the long-term cost of your home.
Why Credit Scores Matter for Mortgage Rates?
When it comes to obtaining a mortgage, your credit score plays a crucial role in determining your rate. Lenders need to consider the long-term risk of lending you money for 30 years, and a credit score gives them an idea of how likely you are to make payments responsibly, even if your circumstances change. It’s not just borrowers with low credit scores that pay the price, either. Even a slight difference in score can add up over the life of a loan.
For example, someone with a credit score in the 680-699 range may have a mortgage rate that is approximately 0.399 percentage points higher than someone with a score in the 760-850 range. This may seem like a small difference, but it can add up to significant amounts of money over time. For example, on a $244,000 mortgage, someone with a 680-699 score may pay over $20,000 more in interest over 20 years compared to someone with a high score.
So, what credit score do you need before applying for a mortgage?
Understanding Which Credit Score Matters Most
As a consumer, you may be aware that you have multiple credit scores, and the FICO score you access through your credit card company may not be the same one your mortgage lender considers. This is because credit information is held by three major credit bureaus (TransUnion, Equifax, and Experian), and while they all calculate FICO credit scores, their data may vary slightly, leading to differences in scores. Additionally, FICO updates its scoring methodology over time, resulting in many potential scoring models for lenders to choose from. In fact, the Consumer Financial Protection Bureau states that FICO has offered more than 60 scoring models since 2011.
However, there is some good news: Fannie Mae and Freddie Mac, the government-sponsored enterprises that purchase many of the mortgages originated in the US, set rules for the loans they buy. Therefore, while your bank may have their own policies for specific types of loans, they likely comply with the standards set by Fannie and Freddie in case they want to sell loans off their balance sheet (which most banks do). Fannie and Freddie actually require much older versions of the FICO credit score, which means that the score pulled by your credit card company or a website like Credit Karma may not be the same as the older version used by these organizations. To get a copy of the right score, you can purchase it from myFICO.com.
However, it’s worth noting that if your score is excellent according to the newer version of your credit report, the older version is likely to be good as well. If your score is low, you can use the newer version of your credit report to make changes and improve your score before paying for the older version. On the other hand, if your score is borderline, it may be worth the money to purchase your credit scores as calculated by data from all three credit bureaus. The myFICO reports will note which scores are most widely used in mortgages, so you can easily compare them. When purchasing your FICO scores, it’s always best to opt for all three bureaus unless you know which agency your lender plans to use. Otherwise, if a lender pulls two scores, they will take the lowest (or the middle if they pull all three), and you want to know what those scores could be.
How Much Can a Good Credit Score Save You?
When it comes to comparing mortgage rates, the difference between two rates may seem small at first glance. However, over the course of a 30-year mortgage, that small difference can add up significantly. For example, let’s say we’re looking at a $244,000 mortgage for a $305,000 single-family home with a 20% down payment, which is the current average mortgage balance in the US. Using the Loan Savings Calculator from myFICO, we can estimate the national average interest rate and total cost of this mortgage.
The difference between a good credit score (660-679) and an excellent credit score (760-850) can have a significant impact on your mortgage rate. Someone with an excellent credit score may be able to secure a 30-year fixed mortgage with an interest rate of 4.147%, which is more than 0.6 percentage points lower than the 4.76% interest rate for someone with a good credit score. This difference in rate can result in a higher monthly mortgage payment and a higher total interest cost over the life of the loan. For example, a person with a good credit score may pay $214,745 in interest on their mortgage, while someone with an excellent credit score may pay only $182,840. That’s a difference of over $30,000 in interest costs for the same house.
But the impact of credit scores on mortgage rates goes beyond just the interest cost. A higher interest rate not only results in a higher monthly payment, but it also reduces the amount of principal you pay off early in the loan. This means that those with higher credit scores may be able to build equity in their homes faster and at a lower cost than those with lower scores. For example, in the first ten years of a mortgage, someone with a good credit score may have made $151,631 in total payments, but only $46,485 of that would go to the principal. Meanwhile, someone with an excellent credit score may have made $141,094 in total payments, but paid off over $3,800 more in principal with those payments.
You Need an Excellent Credit Score for the Best Rates
So, what does all this information mean for you as a homebuyer? Before you start shopping for a house, it’s a good idea to take a look at your credit score. There are steps you can take to improve your score, such as checking your credit reports for errors, paying off your credit card balances in full each month to lower your debt utilization, and making all your payments on time. These actions can help you boost your score before you apply for a mortgage.
When it comes to the minimum credit score needed to secure the lowest mortgage rates and private mortgage insurance (PMI) rates, it depends on the size of your down payment. If you plan to put less than 20% down on your new home, you’ll typically need a credit score of 760 or higher. However, if you’re making a down payment of 20% or more, a credit score of 740 is usually enough to get the best mortgage rates and loan terms.
Even if you can’t achieve the highest possible credit score, just a few points can make a difference in your mortgage rates. For example, a small increase in your credit score may move you into a higher underwriting level, which could qualify you for somewhat lower rates. Over time, this small difference in rate could save you thousands of dollars in interest costs.