This probably comes as little surprise to most folks, but America pretty much runs on credit. According to newly released data from the Federal Reserve, aggregate credit card debt in the U.S. now totals $1.027 trillion, an all-time record. Aggregate credit card debt also joins student loan debt and auto loans over the $1 trillion mark. Given that the U.S. economy is 70% consumption-driven, this isn't all that shocking.
This credit card usage is what's helping to build our credit profiles, which lenders use to determine if we're worth lending to or if we should be shown the door. Perhaps the best-known credit-scoring system comes from Fair Isaac Corp., which you probably are familiar with as FICO. Your FICO credit score ranges from a low of 300 to a high of 850. The higher you credit score is, the more favorable your interest rates and options will be when looking to get a mortgage or open a credit account. A higher credit score can also help lower your home and auto insurance rates, minimize or eliminate utility deposits, and help you land your dream job, apartment, or home.
Your credit score has major impact on your mortgage APR
Most people are probably under the impression that there's a pretty definitive line in the sand that can be drawn where you either have good credit or you don't. But there's much more to it than that. If you're looking to buy a home, mortgage lenders can charge a markedly different annual percentage rate (APR) based on your credit score. In some instances, even a 10- or 20-point swing could mean a lot of extra money out of your pocket over the life of a loan.
By way of Informa Research Services, myFico.com recently published the average APRs for a 30-year fixed home loan -- the most popular term for a mortgage -- based on a person's FICO score. Here's the breakdown, as of Aug. 23, 2017, for a $300,000 mortgage:
- FICO Score of 760-850: 3.512% APR
- 700-759: 3.734% APR
- 680-699: 3.911% APR
- 660-679: 4.125% APR
- 640-659: 4.555% APR
- 620-639: 5.101% APR
Perhaps the first thing you'll notice is that there's no aggregate data for consumers with a credit score of 619 or lower. Traditional lenders tend to avoid this subprime group as a high delinquency risk. That doesn't entirely preclude those with poorer credit scores from owning a home, though. Federal Housing Administration (FHA) loans may offer assistance to those with credit scores as low as 500, depending on how much you're able to put down on a home. Nevertheless, scores of 619 and lower make it very difficult to get a traditional home loan.
You'll also note that a very prominent increase in APRs begins once you move well beyond the "good" or prime category (700 and above) into the "near-prime," or what we might call "average" scores. Lenders have to account for an increased risk of default for those below prime, and they do so by passing along higher interest rates and/or fees during the homebuying process. APRs take into account interest rate costs, as well as homebuying costs, over the life of the loan.
Poor credit could cost you
How big of a difference are we talking with those APRs? As an example, a $300,000 mortgage for someone with an 800 FICO score would run $1,349 a month. The price jumps to $1,387 a month for a 700 FICO score, $1,454 for a 675 score, $1,530 for a 650 score, and $1,629 if you have a 625 score. Again, these are average figures from Informa Research Services, and your individual market and relationship with your financial institution could have some bearing on these APRs. Nonetheless, that's a big difference.
It's even bigger when we begin talking about life-of-loan costs. A consumer with a FICO score of 800, utilizing a 3.512% APR, would pay $485,692 for a 30-year loan, including interest. By comparison, an individual with a 675 FICO score would fork over $523,422, and a 625 FICO score would pay $586,452. That's more than $100,000 extra over 30 years for a credit score difference of as little as 121 points (639 to 760).
Those with poor credit scores are considered to be a bigger risk for lenders, and therefore they have fewer lending options to begin with. On the other hand, folks with excellent credit scores (760-850) have banks fighting for their business, and thus the ball remains in their court.
Sticking to the basics can easily improve your credit score
There's no magic wand to wave that'll improve your credit score overnight. Instead, sticking to the credit basics is going to be your best bet to improve your credit score to secure the lowest APR possible when buying a home.
Although FICO is secretive about its exact credit formula, there are five factors that help FICO come up with your score -- some clearly with more importance than others. Following are those five factors, listed with their relative weighting in parenthesis:
- Payment history (35%)
- Credit utilization (30%)
- Length of credit history (15%)
- New accounts (10%)
- Credit mix (10%)
As you'll note, your payment history and credit utilization make up almost two-thirds of your credit score, so this is where you'll want to focus most of your attention if you want to boost your score as quickly as possible.
Your payment history takes into account the timeliness of your payments. If you have a long history of paying your bills on time, your lenders are probably going to be more willing to lend to you at an attractive rate. If, however, you do have a recent late payment on your credit report, but you've had a long history of on-time payments, consider asking your lender to forgive your tardiness. If you're a good credit customer, chances are the lender will, because it costs far more for lenders to get new customers than to keep customers with good and excellent credit happy.
In terms of credit utilization, FICO suggests keeping your aggregate usage below 30%. In other words, if you were to add your credit limits for all of your credit accounts together, FICO would like to see you use less than 30% of that amount. It's possible you may also be penalized for too heavily utilizing a single card. The general rule here is to use credit wisely and avoid leaning too heavily on your credit cards.
The other three factors -- length of credit history, new accounts, and credit mix -- make up the final third of your score. In this instance, your best bet to improve your score is to keep long-standing good accounts open for a long period of time. A big mistake consumers make is closing accounts in good standing that aren't being used much. These accounts offer valuable data points for lenders, and they can lift the average amount of time your credit accounts have been open.
Similarly, avoid opening new accounts that don't make financial sense (i.e., don't open a department-store card to save 10% on a $15 purchase), and do try to demonstrate that you can handle revolving loans and installment loans. Mortgages and auto loans are examples of installment loans, while a department-store credit card is an example of a revolving account.
Just keep in mind that bettering your credit score takes time. The more positive data points you can provide, the better road map you create for lenders. This won't happen overnight. But there's never a better time to improve your credit score than now. What are you waiting for?\