For most Americans, a home is the largest purchase they’ll make in their lives. As we’ve discussed elsewhere, shopping for a mortgage is a fairly complex process. Ideally, you’ll apply with several different lenders.
Additionally, you need to provide a variety of financial documents, and make sure that your credit is in order. If you complete the process succesfully, then you’ll be able to purchase a home.
Minimum Credit Score Requirements For Mortgages
In order to qualify for pretty much any mortgage, you need to meet at least minimum credit score requirements. If you hope to borrow through the FHA loan program, which is popular with first-time homebuyers, and you want to place a low down payment (a minimum of 3.5%), you’ll need a middle mortgage FICO score of at least 580. If your score falls between 500 to 580, you’ll need to put a minimum of 10% of the home’s value as a down payment.
FHA loans are backed by the Federal Housing Administration (a government agency). This is why they’re able to accept borrowers with lower credit scores and smaller down payments.
Of course, for FHA loans, many mortgage lenders still ask for a credit score which is somewhat above the minimum requirements – typically 620 or higher. FHA properties typically have to fall under certain price limits (which are different for each county in the United States).
For conventional mortgage loan (those which are not backed by a government agency), you typically need a score of 620 or higher. As with FHA loans, some lenders ask for scores which are above the typical minimum of 620.
VA loans are mortgage products for veterans, which are backed by the US Department of Veterans Affairs (popularly known as the VA). While the VA does not set minimum credit score requirements, most lenders will set their own minimums, ranging from 580 to as high as 640.
How Mortgage Interest Rates Are Impacted By Credit Scores
Of course, qualifying for a mortgage is just the first step. You also need to consider what sort of interest rate you’ll end up paying.
Your interest rate is determined almost entirely by your credit score. The higher your credit score, the lower your interest rate. Of course, this also means that the lower your credit score, the more you end up paying in interest. This is known as risk-based pricing. If you have a poor credit score, you’re seen as a greater risk for the mortgage lender, and they’ll thus charge more for your loan.
Let’s take a close look at how mortgage rates are impacted by credit scores. MyFico has an excellent mortgage loan calculator. Using this calculator, with today’s mortgage rates (it’s July 16, 2020), we can calculate your interest rate (and thus monthly payment) for various mortgage amounts.
Keep in mind that it is very much possible that the interest rate a lender will offer you, is either lower or higher than this amount. Either way, however, this is a good gauge of where you stand.
Source: Myfico.com
For a $200,000 mortgage, and a credit score over 760, you’ll pay $819 per month in principal and interest (that does not include insurance or property taxes). Your interest rate is a very low 2.777%.
If your score drops to somewhere between 680 to 699, your monthly payment will increase to $862, or $43 more per month. Your interest rate is a still low 3.175%.
This might not seem like a lot, but ask yourself if you could think of better things to do with an extra $516 per year, instead of giving it away to the bank? I’ll bet you can.
If your score heads even lower, to the 620 to 639 range, your interest rate now skyrockets to 4.361%. You’re paying $997 in principal and interest – that’s $178 extra every month, as compared to if you had a 760+ FICO!
Added up over a year, you just spent $2136 more than you had to. Let’s take a step back for a moment.
What if you had invested that $2136, in the stock market? Or simply used it to save for a rainy day? Of course, if your score falls below 620, you’ll end up paying even more – that is, if you can even find a lender to work with you.
Clearly, a low credit score can cost you a lot when it comes to buying a home. If you can purchase with a higher credit score, you’re certainly better off.
With that said, there can be other considerations, and certain instances in which purchasing today, with a lower credit score, isn’t a bad idea. Let’s take a look at a few of these situations.
#1: Home Prices Are Increasing In The Area Where You Want To Buy
One consideration is the direction in which home prices are heading. Suppose you’re buying in an area where home prices are steadily increasing, over the past few years.
In such a situation, it will probably cost you more to purchase a home in a year or two, as compared to buying now. Therefore, if you purchase (with a lower credit score) today, you might be better off, as compared to buying with better credit, a few years down the line.
Remember, it is possible to refinance your mortgage, into a lower rate loan. If you purchased with a lower credit score, you can work on improving your score, over the course of a year or two. Having a mortgage on your credit reports, which is always paid on time, will certainly have a positive impact.
After improving your score, you can refinance (i.e. take out a new mortgage), which is used to pay off the old mortgage. You’ll now repay that loan, at the lower interest rate. This will save you money as the years go by.
#2: Interest Rates Are Expected To Decrease (Or Remain Low)
If you’re buying during a time when interest rates are low, and are expected to stay low, then refinancing into a lower rate should be an option not just today, but into the future. This means that if you purchase at a higher rate today, you should be able to refinance into a lower rate tomorow.
Let’s say you purchased your home with a mediocre credit score, and so paid a somewhat higher interest rate. Over the course of a year, you improve your credit score substantially. Given that interest rates remain around the same rates as when you purchased (or are a bit lower), you can easily refinance into a mortgage with a reduced interest rate.
Given these realities, it could make sense to purchase with a lower credit score (and higher interest rate), and to refinance once your credit score has improved. After all, it’s not as if you can’t obtain the same interest rate (or lower), and save money, in the near future.
The Final Word
Clearly, when it comes to mortgages, credit scores are incredibly important. In many cases, it makes sense to wait until your credit score is as strong as possible, before purchasing a home. If home prices aren’t rising particularly fast, or interest rates are likely to increase (meaning, you can refinance into a lower rate in the future), then waiting to purchase might make sense.
In other situations, however, you might want to go ahead and buy a home with a somewhat lower credit score (and thus, higher interest rate), and refinance later. If home prices in your area are increasing, or interest rates are expected to remain low, this can be a good approach.
If you aren’t sure how to improve your FICO score, you might want to check out our Credit Builder Secrets e book. There, you’ll learn 21 strategies to build, manage and improve your credit scores. Get the book here.
