If you plan to use a mortgage for your next home purchase, youâ€™ll
want to keep your credit scores as high as possible. Credit scores play
an out-sized role in determining for which mortgage product youâ€™ll
qualify, and to which rate youâ€™ll be assigned by your lender.
The higher your credit score, the lower your mortgage rate will be.
What Is A Credit Score?
History has shown that the best way to predict a personâ€™s behavior
over the near-term future is to look at that personâ€™s behavior in the
recent past.Â Itâ€™s a concept similar to theÂ First Rule of Physics â€” an
object in motion tends to stay in motion.
We can apply this theory to consumer credit, too. A person who has
recently paid his bills on-time should continue to pay his bills on-time
in the near-future.
This is the basis of credit scoring; using your past to predict your future.
To mortgage lenders, your credit score represents your likelihood of
making on-time mortgage payments for the next 90 days. â€œ90 daysâ€ matters
because, after 90 days without payments, a homeowner falls into
Higher credit scores correlate with lower default risk which explains
why people with high credit scores tend to receive lower mortgage rates
than people with low credit scores. This is true across all loan types,
including conventional, jumbo, and FHA mortgages.
Like most else in finance, those with the lowest risks get to pay the lowest rates.
Lenders Use The FICO Scoring Model, Exclusively
There are three main credit bureaus in the United States. They are
Equifax, Experian and TransUnion. Each offers a bevy of credit-scoring
products, available for purchase on their respective websites. Prices
range from â€œfreeâ€ to several hundred dollars.
None, however, are particularly relevant in the home-buying process.
This is because the nationâ€™s mortgage lenders rely on a different credit
model â€” the FICO model.
FICO is named for the Fair Isaac Corporation. It was â€œinventedâ€ in
the 1950s and has become the mortgage industry standard for credit
ratings. Today, FICO scores are omnipresent to the point that people
generically refer to all credit scores as â€œFICO scoresâ€.
This isÂ akin to calling all adhesive bandages â€œBand-Aidsâ€. FICO is the brand name â€” not the product.
FICO scores range from 300-850.
Credit Scores Change Mortgage Rates
Your FICO score has always influenced the mortgage rate for which
youâ€™re eligible. In 2008, though, it began to change your loan fees.
In response to major mortgage market losses, in April 2008, both
Fannie Mae and Freddie Mac introduced something called Loan-Level
Pricing Adjustments (LLPA).Â Loan-level pricing adjustments are â€œdiscount
pointsâ€ added to a mortgage rate, based on a specific borrowerâ€™s risk
to the lender.
A discount point is a loan fee, paid at the time of closing. 1 discount point is equal to 1 percent of your loan size.
Example : A $300,000 mortgage thatâ€™s assessed 1 discount point will have $3,000 in extra fees due at closing.
Fannie Mae and Freddie Mac know that low credit scores correlate to
high default rates so, like an insurance policy, they assigned the
highest costs to the highest-risk borrowers.
Assuming a 20% downpayment, look at how discount points change based on credit score. Fees get massive for FICOs under 700.
- 740+ FICO Â : There are no discount points required. This loan is â€œlow riskâ€.
- 720-739 FICO :Â Â 0.250 discount points are charged to the borrower, or $250 per $100,000 borrowed
- 700-719 FICO :Â Â 0.750 discount pointsÂ are charged to the borrower, or $750 per $100,000 borrowed
- 680-699 FICO :Â Â 1.500 discount points are charged to the borrower, or $1,500 per $100,000 borrowed
- 660-679 FICO : Â 2.500 discount points are charged to the borrower, or $2,500 per $100,000 borrowed
Now, not many new home buyers just have that kind of extra cash just
laying around. Therefore, as an alternative to paying discount points
with cash, many choose to â€œroll upâ€ the fees into their respective
mortgage rates.Â In general, 1.000 discount point can be â€œtraded inâ€ for a
0.250 increase to your mortgage rate.
Example : A consumer with a 680 FICO score is required to pay
1.500 discount points at closing, or can alternatively accept a
mortgage rate increase of 0.375%.
This is why itâ€™s important to keep your credit score high. There are real dollar costs for having scores under 740.
Improving On Your Credit Score
If your credit score is not as high as youâ€™d like, the good news is
that you can take steps to raise it â€” sometimes without even changing
your spending habits.