Here’s how bad credit affects your mortgage
Borrowers who come to the table with lower credit scores may find that their mortgage costs more because of their bad credit scores. This is true for first-time home buyers as well as for people buying a second or third home. A loan costs more for someone with bad credit because of the higher interest rates and the resulting higher monthly mortgage payments imposed on people with less than perfect credit.
Here’s a look at why and what your options might be if your credit score is less than ideal.
What is a classic mortgage loan?
A conventional fixed rate mortgage is a home loan issued by a bank, lender or mortgage broker and sold in 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 loans. And the interest rate and terms are almost always fixed for the life of the loan. The majority of mortgage loans are conventional loans.
The terms and interest rate of a conventional loan are determined using what mortgage lenders call “risk-based pricing”. This means that the costs are based on the apparent risk to the consumer’s financial situation. It also means that different people get different terms and interest rates depending on the risk their financial situation presents to the lender regarding loan repayment and payments on time.
If you have a lower credit score (from bad to bad or fair), lenders consider you a higher risk and, if they approve you for a conventional mortgage, they will charge you a higher interest rate. which will result in a monthly payment and a higher cost for the entire loan in the end.
The additional cost of bad credit for a conventional mortgage
With a conventional mortgage, your credit score is the biggest factor in your costs.
If your credit score is between 620 and 679, you can expect higher costs when:
You don’t have at least 20% down payment (or 20% equity if you’re refinancing)
Your loan amount is greater than $ 417,000 – or whatever your county’s compliant loan limit is
You refinance to reduce your monthly payment
Other factors that affect the price and rate of a mortgage include occupancy, type of property, loan-to-value ratio, and loan program.
Let’s say your home buying scenario looks like this:
Conventional fixed rate loan
630 credit score
Loan amount of $ 417,000
Due to your lower credit score, it is not uncommon for you to pay an interest rate that is 0.375% higher than the 30-year average primary mortgage rate and higher than someone with a credit score. above 800. The primary mortgage rate is 3.875%, a person with good credit would pay 4.125% interest (0.25% above the primary rate) and you would pay 4.5%.
Your monthly payment would be $ 2,112.88 versus 2,029.99, or $ 82.99 more each month and $ 29,876.40 more over the 30-year term of the loan. Ouch!
Also, when you have a down payment of less than 20% (so you are financing 80% or more of the price of the house), your lender will require them to pay a mortgage insurance premium. This private mortgage insurance premium (PMI) could represent 110% of the loan amount on an annualized basis.
Here again, your creditworthiness is factored into the PMI amount of a conventional loan: the lower your score, the more mortgage loan insurance you will pay. For someone with a credit score of 630, that could be $ 4,587 per year or $ 382 per month. Another ouch!
For someone with a credit score of 700, the mortgage insurance premium would be about $ 3,127 per year or $ 260 per month, a saving of $ 122 over your rate or $ 1,464 per year.
The bottom line
It is beneficial to have a good credit rating when applying for a conventional loan. If you’re planning on buying a home in the next year or so, now is the time to check your credit scores and credit reports, and come up with a plan to build your credit. A lender can also guide you on the best steps to take.
Don’t be afraid though. If you need to get a home loan now, you may be able to get one with lower credit and improve your score after the fact, then refinance for a better interest rate and better monthly payment. There are also other loan options available for people with lower credit scores.
How to lower your mortgage costs if you have bad credit
You may be able to increase your credit score just by paying off your credit card debt. Use a credit card refund calculator to see how long it might take to pay off your credit card debt. Paying off your debts reduces your debt to income ratio and makes you appear less risky in the eyes of lenders.
Also be aware that your overall credit history will affect how quickly paying off debt affects your score. If you have a long history of late payments, it will take longer to make payments on time now to improve your score.
As a general rule, a good financial rule is to keep your credit card balance at no more than 30% credit card credit limits, also known as the credit utilization rate, which is an important part of your credit score.
In addition to paying off your debt, ask your mortgage advisor if they offer a free credit check. In addition to checking your score and getting your free credit card on Credit.com, a mortgage-specific credit analysis can help you see what factors are affecting your mortgage interest rate. You can then focus on improving these factors first.
Most mortgage brokers and direct lenders offer a credit analysis service. By having the mortgage company perform the analysis, you can see how much your credit score could increase by taking specific actions.
You can also consider putting more money into buying a home to help offset a lower credit score, if at all possible of course.
Or, you might want to change gears and go for a different mortgage program. An FHA loan is another viable avenue to keep your monthly mortgage costs affordable. It may also be easier for you to qualify for a FHA loan with a lower credit score.
The Federal Housing Administration or FHA grants FHA loans. It does not weigh as heavily on credit scores as private lenders who provide conventional loans. There is no sliding scale based on your credit score like there is with a conventional loan.
An FHA loan charges an initial mortgage insurance premium of 1.75% typically funded by the loan, but the effect of the payment is not large, which can make an FHA loan a lower cost monthly alternative to a conventional loan for someone with a lower credit rating.
Other information about FHA loans:
FHA Loans aren’t limited to first-time homebuyers, they’re open to everyone
FHA loans can be used to purchase a home or to refinance an existing FHA home loan.
If you are looking for a mortgage and trying to buy or refinance a home, consider working with your loan officer to qualify up front for as many loan programs as possible. This approach gives you the flexibility to choose the loan that’s best for you, taking into account your payment, cash flow, loan goals, and budget.