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If you want to purchase your first home, credit score is needed to determine if you qualify for a loan. Even if you have put away a lot of savings in the bank, it makes more sense to get a mortgage, especially if you don’t want to tie up your liquid assets to real estate. This will free your funds for possible business prospects and emergencies that will require cash. But it can be a highly complex process to borrow the amount of money needed to buy a house.
Imagine that someone is asking you for a loan. Even if you are the type of person who is always willing to help someone in need, most likely, you will want to know more details about this person, especially if they are an absolute stranger. You might want to know what they need the money for, how they plan on paying you back, and when the funds will be returned. These are the same questions that will run in the minds of lenders when you apply for a loan.
However, your credit score can play more than one role in your mortgage application.
Today, let’s find out how your credit score can affect your homebuying future. Why are credit scores the norm, and how do you use your credit to prepare for your mortgage journey?
What are credit scores?
In certain communities, we can build our reputation. Based on past actions, people can get to know us and create their opinion of who we are.
When we apply for any loan type, we enter into a new responsibility and relationship. Due to the seriousness of this financial transaction, the application will entail a ton of paperwork and verification. There is a lot of work involved in underwriting a potential borrower. It makes it easier for lenders to use one specific detail to give them an overview of someone’s qualifications: their credit score.
The way the system works, credit scores can be an unfair tool for denying someone of essential housing. But that’s not the only way credit scores can affect our lives.
Aside from lenders and landlords, employers frequently conduct credit checks for job candidates. The logic is if the job entails handling sensitive clientele information, your boss will want to know if you can be trustworthy and reliable, which are purportedly some of the character traits that our credit scores reflect.
In a survey by the Society for Human Resources Management, it was found that about 47% of employers do some form of credit history check on job hopefuls. So if you have bad credit, apart from not qualifying for a car loan or mortgage, you can possibly miss out on a good employment position.
Unfortunately, judging someone’s qualifications based on credit score alone can be considered as discriminatory treatment. This is because several factors affect credit aside from behavior. After all, nobody wants to have bad credit, especially if you end up with fewer options.
Now, it’s time to get to the basics of credit scores.
At this point, you’ve probably heard of FICO, which is the credit scoring system used by the three big credit bureaus: Equifax, Experian, and TransUnion. Other types of ratings may be used in the industry, such as the VantageScore 3.0 credit score, but the FICO Score is the most common. So for this article, we will base our information on the Fair Isaac Corporation’s scoring system.
No one is born with credit. They say that it is something you earn based on the three C’s: character, capacity, and capital. Your credit history is composed of accumulated data the moment you start paying back a debt. It contains your payment history, list of accounts and amounts owed, and other financial information. If you don’t have any of this data, you will not find a credit score under your name. While the absence of a credit rating is possible, though, a zero FICO Score is not.
Your FICO Score will be a number from 300 to 850, and most likely, yours will be over 500 because this is the minimum credit score of 99% of American borrowers. Only a tiny fraction of people tend to get 300 credit scores, which account for the most extreme circumstances.
Ideally, whether you need to buy a house, get a job, or a credit card, you want to be in the Good FICO Score range, which starts at 670. You can achieve this by consistently paying your bills on time, keeping your credit utilization low, and using your credit card wisely.
When people talk about bad credit, these are FICO Scores from 300 to 669.
How does my credit affect me if I want to buy a house?
Thirty-five percent of your FICO Score is based on your payment history. This is why even if you make only one late payment, it can pull down your score significantly, and it can be a long time before your credit score recovers.
Most types of mortgages require a minimum credit score to make you eligible. If your FICO Score doesn’t meet the cut, there’s generally no further use submitting an application. On the other hand, if your rating meets the minimum credit score requirements, later on, it can also influence your mortgage rates, loan amount, and minimum down payment. Needless to say, the higher your credit score, the better features or benefits you can get for your mortgage.
Here are some examples:
1 – Automated underwriting
Government-backed loans like USDA loans and VA loans technically state that no specific credit score is needed to qualify for a mortgage insured by either the U.S. Department of Agriculture or the Department of Veterans Affairs. However, there is a credit score that mortgage lenders might prefer should you apply.
Many people will be able to close their USDA loans faster, particularly if they have a credit score of at least 640. This is due to automated underwriting. As part of the loan origination process, you will be asked to prove your ability to repay the mortgage if you don’t meet this credit score.
If your credit score is above 640, your mortgage can be automatically underwritten. If not, someone will have to manually underwrite your loan, and the additional paperwork can extend the process a lot longer than you might expect. On average, a manually underwritten loan takes a further 30 days before closing.
2 – Down Payment
For mortgages that will require you to make a down payment, your credit score can dictate just how much you need to pay.
The Federal Housing Administration authorizes lenders to approve borrowers with a minimum credit score of 500 for FHA loans. If borrowers have this minimum credit score, they will need to make a down payment equivalent to 10% of the home’s purchase price. However, if they have a credit score of 580 or higher, a 3.5% down payment can be allowed.
Surprisingly, a 10% down payment can make your mortgage cheaper. This is because the monthly mortgage insurance fee can be stopped after eleven years when you can pay at least 10% down on an FHA loan. Otherwise, you pay for mortgage insurance until you fully pay off the loan.
For conventional loans, you need to make a minimum 20% down payment to skip insurance from the get-go. There’s no waiting time of eleven years, unlike for FHA loans. Unfortunately, for conventional mortgages, you need a minimum credit score of 620 to be eligible.
3 – Loan Amount
Lower credit can limit the size of the real estate property you will be eligible to buy.
Every type of mortgage has a corresponding loan limit that changes annually according to the prescription of Fannie Mae and Freddie Mac. These limits also vary according to your location.
However, some mortgages do not conform to Fannie Mae and Freddie Mac loan limits. For example, if you want to live in a much bigger house, a jumbo loan may be what you need. Jumbo loans are one type of conventional loan. Unfortunately, these mortgages can ask for a much higher credit rating. Some lenders may prefer a credit score of at least 680 before approving your loan amount.
The larger your loan amount, the higher credit score you will need.
4 – Interest Rate
No particular credit score will dictate your mortgage rate, but some loans tend to have a more expensive interest rate. So if you get disqualified for some home loans based on your credit score, this can limit your mortgage options to the choices that ask for higher interest.
One type of bad credit mortgage that many borrowers fall back on is called Non-QM. This stands for Non-Qualified Mortgage.
In essence, if you don’t meet a lot of conventional or government-backed loans’ requirements, a Non-QM loan can still make homeownership possible for you. With Non-QM, even if you’ve been through foreclosure or bankruptcy, there will still be lenders who’ll be able to process your application, with the caveat that you have to pay for a much higher interest rate. For this reason, Non-QM loans should only be considered when you can no longer wait to buy a house. Otherwise, you will be better off with an FHA loan.
According to Experian, 44% of American consumers have at least one mortgage as of 2020.
To qualify for a mortgage, you need to have a good credit score to satisfy a loan’s minimum credit score requirements. Although some loans indeed do not have this usual demand, your credit can still determine how much you will eventually pay for your mortgage, and the difference can be up to thousands of dollars.
While not everyone will want to buy a house, everyone has the right to adequate housing. And the good news is, despite how credit can filter your loan options, there will always be at least one type of mortgage that will fit your home loan needs, whether it is an FHA loan, a conventional loan, or a Non-QM loan.
If you haven’t learned your credit score, it’s high time that you get your credit report from the three major credit bureaus. Did you know that you are entitled to at least one free credit report per year? If you have the foresight to aim for a particular credit score, you stand to gain a lot of savings for your mortgage.
Check your credit reports now so you can buy yourself time to improve your credit score.