When getting a home loan, your credit score is more important than ever. Your credit score determines the amount of financial risk you hold to a lender. A lower credit score means a higher potential risk to a lender that a borrower won’t repay the loan. Borrowers with higher credit scores are rewarded with more options and lower interest rates.
What is a Credit Score?
A credit score is a numerical score based on an analysis of someone’s credit history. In regard to a mortgage, a credit score determines the level of risk a borrower is to a lender based on the borrower’s willingness and ability to repay debt.
How is a Credit Score Calculated?
Scores range from 350 to 850. Your score is calculated through an analysis of your current credit situation which includes any debt, payment history and types of credit. It is important to note that payment history accounts for only 35% of your overall score, that means it takes more than just paying your bills on time to increase your score.
How Can I Maintain or Improve my Credit Score?
Pay attention to the amount owed verses the credit limit, length of credit history, new credit accounts and types of credit in use. A good goal is to keep revolving (credit card) balances below 50% of the credit limit. Also, limit the number of new accounts you open each year; hang onto that credit card you’ve had for years even though the rate may be slightly more than the latest rate offering; and avoid high-interest personal loans. Here are five ways you can work on improving your credit score today.
What Credit Score Do I Need to Get a Home Loan?
In the current mortgage market, borrowers need at minimum a 720 score in order to obtain the best rate. From there, rates increase in 20-point increments down to 620, where you’d be paying a much higher rate than the borrower at 720. Keep in mind, a home loan is typically our largest debt. Is it really worth opening a new credit card to save a small amount of interest when that may cause you to pay thousands extra in mortgage interest?
Credit Reporting Errors
Credit reporting errors are something to keep an eye on because many credit reports contain errors. Some reports contain mistakes that are bad enough to cause an applicant with good credit to be denied. Taking this into account, the first step in putting your best foot forward is making sure everything in your credit file is correct. Watch your credit report closely. Get a copy of your credit report every six months and get the report from a reputable source that provides accurate scoring (see some reputable sources below.)
Many on-line sites use their own scoring system that is different from what lenders see when the official report is pulled. If you find a mistake, notify all three reporting agencies immediately. Once notified, the agency has 30 days to investigate and respond. If the information being reported cannot be confirmed, the item should be removed.
For lenders, income is another tool used to assess your overall risk factor. Let’s be honest, if you’re looking to get financing in the next few months, it is unlikely that your income will change drastically during that time. However, whether you are salaried or self-employed, there are a number of tax implications that can have a negative impact on your debt to income ratio (DTI). The DTI is calculated by dividing the amount of your monthly payments by your gross monthly income. There is not a “set in stone” DTI requirement, but a good rule of thumb is to keep it under 41%.
This is an area that most borrowers don’t consider, but the more money you have left after closing (also called reserves), the less risk you pose in the eyes of lenders. This takes into account any liquid assets (checking, savings, money market, etc.), investment accounts, retirement accounts, etc. A down payment will, in most cases, be required. The risk on a loan increases when every dollar saved must go into the transaction for down payment. Once again, there is not a “set in stone” requirement, but it’s a good idea to save at least two months’ worth of mortgage payments in reserve after closing. More is definitely better in the case of reserves.
These are all factors that are looked at when lenders make a decision on whether or not to approve your mortgage. In many cases, one can be overcome by another. If credit score is just a bit off, but the DTI is low and assets are strong, don’t count yourself out. These are called “compensating factors.” Always work on deficiencies in credit, which can be improved with reduced debt and increased savings.
Reputable Credit Report Sources
P.O. Box 2002
Allen, TX 75013
P.O. Box 1000
Chester, PA 19022
P.O. Box 740241
Atlanta, GA 30374