Borrowers who come to the table with lower credit scores can find that their mortgage loan costs more because of their bad credit scores. This is true for first-time buyers as well as people buying second or third homes. A loan costs someone with a bad credit score more because of higher interest rates and the resulting higher monthly mortgage payments imposed on those with less-than-perfect credit.
Here’s a rundown of why and what your options might be if your credit score is less than ideal.
What is a conventional mortgage loan?
A conventional fixed-rate mortgage is a home loan originated by a bank, lender or mortgage broker and sold on the primary mortgage market to Fannie Mae and Freddie Mac. Conventional loans are not guaranteed to a government agency where some loans are, such as FHA and VA loan. And the interest rate and terms are almost always fixed for the life of the loan. The majority of home loans are conventional loans.
A conventional loan’s terms and interest rate are determined using what mortgage lenders call “risk-based pricing.” That means that the costs are based on the apparent risk of the consumer’s financial situation. It also means that different people get different terms and interest rates based on how risky their financial situation makes them to the lender as far as paying back the loan and making payments on time.
If you have a lower credit score—from bad to poor or fair—lenders see you as a higher risk and, if they’ll approve you for a conventional mortgage loan, they’ll charge you a higher interest rate that will result in higher monthly payments and a higher cost for the total loan in the end.
The added cost of bad credit for a conventional mortgage
With a conventional mortgage loan, your credit score is the biggest driver of your costs.
If your credit score is between 620 and 679, you can expect to see higher costs when:
- You don’t have at least a 20% down payment (or 20% equity if you’re refinancing)
- Your loan size is more than $417,000-or whatever your county’s conforming loan limit is
- You’re refinancing to reduce your monthly payment
Other factors that affect the price and rate of a mortgage include occupancy, property type, loan-to-value ratio and loan program.
Let’s say your home buying scenario looks like this:
- Primary home
- Single family residence
- Conventional fixed-rate loan
- 5% down payment
- 630 credit score
- $417,000 loan size
Due to your lower credit score, it’s not uncommon that you’d be expected to pay an interest rate that’s 0.375% higher than the average 30-year primary mortgage rate and higher than someone with a credit score above 800. If the 30-year primary mortgage rate is 3.875%, someone with good credit would pay 4.125% in interest (.25% above the primary rate) and you’d pay 4.5%.
Your monthly payment would be $2,112.88 compared with 2,029.99—that’s 82.99 more each month and $29,876.40 more over the 30-year life of the loan. Ouch!
Also, when you have less than a 20% down payment—so you’re financing 80% or more of the home price—your lender will require that pay a mortgage insurance premium. That private mortgage insurance (PMI) premium might be 110% of the loan amount on an annualized basis.
Here again, your creditworthiness factors into the PMI amount for a conventional loan—the lower your score, the more you’ll pay in mortgage insurance. For someone with a 630 credit score, that might be $4,587 a year or $382 a month. Another ouch!
For someone with a 700 credit score, the mortgage insurance premium would be approximately $3,127 a year or $260 a month—a $122 savings compared with your rate or $1,464 annually.
The bottom line
It pays to have a good credit score when applying for a conventional loan. If you expect to buy a home in the next year, now’s the time to check your credit scores and credit reports and get yourself on a plan to build your credit. A lender can guide you on the best steps to take, too.
Don’t fear though. If you need to get a home loan now, you might be able to get one with poorer credit and improve your score after the fact and then refinance to get a better interest rate and monthly payment. There are also other loan options available to those with poorer credit scores.
How to reduce your mortgage costs if you have bad credit
You may be able to raise your credit score simply by paying down credit card debt. Use a credit card payoff calculator to see how long it might take to pay off your credit card debt. Paying down debt decreases your debt-to-income ratio and makes you look less risky to lenders.
Know too that your overall credit history will affect how quickly paying off debts now will affect your score. If you have a long history of late payments, it will take longer for making payments on time now to improve your score.
Generally, a good financial rule of thumb is to keep your credit card balances at no more than 30% of the credit limits per credit card—this is also known as your credit utilization ratio which accounts for a significant portion of your credit score.
In addition to paying down debts, ask your mortgage professional if they offer a complimentary credit analysis. In addition to checking your score and getting your free credit report card on Credit.com, a mortgage-specific credit analysis can help you see just what factors are affecting your mortgage interest rate. You can then focus on improving those factors first.
Most mortgage brokers and direct lenders offer a credit analysis service. By having the mortgage company run the analysis, you can see how much more your credit score could increase by taking specific actions.
You may also want to consider putting more money down when buying a home to help offset a lower credit score, if that’s possible, of course.
Or, you may want to change gears and go with a different mortgage loan program. An FHA loan is another viable route in keeping your monthly mortgage costs affordable. It may also be easier for you to qualify for an FHA loan with a lower credit score.
The Federal Housing Administration or FHA grants FHA loans. It doesn’t weigh credit scores as heavily as private lenders who give conventional loans do. There is no sliding scale based on your credit score like there is with a conventional loan.
An FHA loan does charge an upfront mortgage insurance premium of 1.75% usually financed in the loan, but the effect of the payment isn’t a lot, which can make an FHA loan a lower cost monthly alternative to a conventional loan for someone with a lower credit score.
Other FHA loan tidbits:
- FHA loans are not limited to first-time home buyers—they’re open to everyone
- FHA loans can be used for the purchase of a home or to refinance an existing FHA home loan.
If you’re in the market for a mortgage and are trying to purchase or refinance a home, consider working with your loan officer to qualify on as many loan programs as possible upfront. This approach gives you the opportunity to cherry-pick which loan is most suitable for you considering your payment, cash flow, loan objectives and budget.
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