Credit is the biggest hot-button topic in mortgage lending by far. Most would probably agree, any time you can raise your credit score to improve your mortgage scenario, consider taking advantage of it. However, every situation is different and here's what to be mindful of if your credit needs a little love.
There are three loan types available on the broader mortgage market today, which includes conventional, FHA, or jumbo. Yes, just three choices. Your credit score determines these things when it comes time for a loan: program eligibility, followed by interest and costs.
Your required middle credit score varies by loan type:
- Conventional loan: 620 or better
- FHA loan: 600 or better
- Jumbo loan: 680 or better
Before going the easy route and assuming that you need to improve your credit score to buy a home, talk with an experienced loan professional. The goal is to determine whether or not you can qualify with the score you have now and, if yes, does it align with your financial goals. If not, taking action-worthy steps can be more technical. Typically, clear and specific action must be followed to improve your credit score. Simply taking the "I'm going to pay my debts down" approach may not cut it.
Mortgage tip: A higher credit score can help you secure a more favorable interest rate, which can keep the payments lower while improving your borrowing power.
Which credit issues should you focus on?
Utilization of credit: The fastest way to get your credit score higher is to strategically pay off the debts that are pulling your score down. Simply put, the biggest reason credit scores are low, independent of late payments, collections, derogatory marks, and little credit history, is utilization of credit. Utilization of credit is a large component of your credit score, and using a high percentage of your available credit can undermine your scores as it signifies you're overextended on credit. The key is to not use your full credit line -- and ideally at 10% or lower. Or if you must carry debt, spread it out over multiple accounts. This also should lower the minimum payments associated with the debt, which can enhance your borrowing ability.
Cost/benefit: A good mortgage company can cherry-pick which debts you should pay off or eliminate completely. This is how you quantify how much benefit there is to improving your credit for better rates and fees.
On-time payments: Paying your bills on time is a surefire way to help your score over time. This can help cement a solid credit history, a key factor in the loan decision. If your credit score is not sufficient for any mortgage loan type you can afford, and cash is tight, take some time to focus on building your credit by making regular and consistent payments.
If, however, your present score does meet the credit standards for the loan option you're eligible for, consider pulling the trigger. While it is always in the best interest of the consumer to reduce debt costs, chasing a lower-cost mortgage for what may or may not happen in the future can be risky.
Mortgage tip: If you're looking at a conventional loan with a 700 credit score or a little higher, and you're trying to obtain better rates and fees, you may be disappointed. Any bettering of rate and fees will be due to market forces that are beyond your control. Here is why: Due to minimal lending credit risk, there is not a dramatic difference between a 700 credit score to even as much as a 740, all other factors being equal on a conventional loan. More specifically, a 15 basis point price difference is to be expected, which by and large is not a monumental change. For example, for a $400,000 mortgage, raising your credit score to 738 might save you $600 in loan costs with the same interest rate. If it requires paying more than $600 of debt to gain 38 points in credit score, it may be throwing good money after bad, especially if your rate remains unchanged.
Which path makes sense for you?
Let's say you are planning to buy a home. You can qualify for an FHA loan now with 3.5% down, but your score is 660. Even though you can afford the mortgage payment, you decide getting your credit score higher is a better financial move so you can secure a conventional loan with slightly more down. Lat's say you estimate that getting your score to 700 will take six to eight months.
This approach can make sense, based on the mortgage numbers alone. But here is where some exposure to financial risk may occur:
- If rates rise, your borrowing power drops, meaning the same-priced home in eight months could end up costing more, resulting in a higher payment, despite a better credit score.
- If housing prices rise, your borrowing power also drops and your cost of housing increases due to paying more for the same home.
- If housing prices rise, you will need more cash to get your foot in the door with the down payment and closing costs, which could possibly interfere with the capital needed to accomplish your credit enhancement plan.
Generally, if you have the ability to improve your credit score by strategically paying down specific debts that should earn you some credit score improvement. And as you go through this process, it can help to track your progress -- you can get two free credit scores, updated monthly, on Credit.com.
That said, it's always best to quantify the exact amount of "benefit" to avoid throwing good money after bad. Often enough, the reward for increasing your credit score may not be as big as you may think. Do your research, get the facts, and then decide.
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