For most Americans, there's no purchase in their lifetime larger than buying a house. Despite the homeownership rate dropping to the lowest level in more than 50 years last year, a whopping 63% of Americans still own their homes as of July 2016. In many respects, homeownership is viewed as part of the American dream and a sign of financial success, and that ethos is unlikely to change anytime soon.
However, the home-buying process is certainly different for everyone – and I'm not talking about the rigors of finding that perfect place to call home. What you might pay for your home compared to another individual or family could be heavily based on your credit report and credit score.
How much can you save on a mortgage with excellent credit?
Generally speaking, the higher your credit score, the more lenders will want your business. The traditional scoring system used by mortgage lenders is FICO's 300 to 850 scoring scale, where anything above 760 typically represents "excellent" credit. Having excellent credit means the ability to play lenders off against one another to get the best rate or perhaps even reduce or eliminate some of the ancillary fees that get wrapped up into your loan. Because lenders realize you've been responsible with your credit (thus your excellent credit score), they'll be far less concerned with your ability to repay your loan.
By comparison, if your credit score is in the 680s, you're considered to have an average credit score. According to a NerdWallet interview with Michelle Chmelar, the vice president of mortgage lending with Guaranteed Rate in New York this past September, a drop from excellent credit down to average credit will typically translate into a roughly 25-basis-point increase in the interest rate.
Using the current 30-year mortgage rate of 4.14% for persons with excellent credit, this means a likely mortgage rate of 4.39% for those with average credit. A 25-basis-point increase may not sound like much, but over the course of 30 years, assuming the loan wasn't repaid early, the excellent credit individual or family will pay nearly $16,000 less in interest than someone with good credit on a $300,000 loan.
Of course, that's not all. Mortgage origination and other associated fees have the potential to rise every time there's a stepdown from excellent credit. Typically, every 20-point bracket below a credit score of 760 leads to another bump up in costs for the homebuyer since the risk to the lender rises. Thus, even though there's probably a nominal 25-basis-point difference between excellent and average mortgage rates, the APR difference, assuming loan origination costs are rolled into the loan, could demonstrate an even larger contrast.
Three factors to keep in mind
So, what should prospective homebuyers keep in mind when shopping around for a mortgage?
First, it's important to take to heart the five factors that can impact your credit score at all times in order to improve your credit score over the long run.
Although FICO is secretive with its exact credit-scoring formula, it did provide CreditCards.com a rough outline. Here are the five factors that can influence your credit score, along with their relative weighting:
- Payment history (35%)
- Credit utilization (30%)
- Length of credit history (15%)
- New credit accounts (10%)
- Credit mix (10%)
As you can see, simply paying your bills on time and keeping your aggregate credit usage under 30% of your available credit accounts for nearly two-thirds of your score. The remainder involves keeping good-standing accounts open for long periods of time, wisely picking and choosing what new accounts to open, and demonstrating that you can handle installment and revolving lines of credit/loans.
Second, it's also important that you pay attention to the current conditions of the mortgage market. Yes, a $16,000 difference between a 680 and 760 credit score isn't chump change. However, with the Federal Reserve in the midst of a monetary tightening stretch, waiting to improve your credit score could wind up costing you considerably more than just caving in now and accepting a slightly higher interest rate and mortgage origination costs with an average or good credit score.
Finally, consider the possibility that alternative options may be available other than a conventional loan.
For example, persons with below-average credit scores may be better served seeing if they qualify for a Federal Housing Administration (FHA) loan as opposed to a conventional loan. If you have a credit score of less than 640, it can become difficult to even get a conventional loan (or get one with a competitive interest rate). FHA loans are often exceptionally competitive with conventional mortgage rates for persons with excellent credit. The catch is that FHA loans typically require that private mortgage insurance (PMI) be paid, since the down payments associated with an FHA loan can be as low as 3.5% for those with credit scores above 580 and 10% for those with scores below 580. PMI is common in instances where a homeowner has less than a 20% initial equity stake in a home.
Having excellent credit can obviously save the average homeowner a lot of money over the life of their mortgage. However, there are still plenty of options and ways for people with good, average, and even poor credit to potentially save money and improve their chances of getting a competitive mortgage rate.