You want to buy a house soon, but you’re not sure your credit score is high enough to get approved for a mortgage. Fortunately, there are ways to improve your credit rating to qualify for a home loan on competitive terms. And if your credit score is at rock bottom because you’re new to credit or you’ve had a series of financial missteps, fear not: damaged credit can also be repaired.
Why You Should Improve Your Credit Score
Even if you currently meet the mortgage lender’s minimum credit score requirements, you should aim for the highest possible credit score. This is because lenders determine your creditworthiness largely based on your FICO scores and base the terms of your loan on your creditworthiness.
The lowest interest rates are usually reserved for consumers with the highest credit score, and an interest rate just 1% lower could result in substantial interest savings over the life of the loan. You will also benefit from a more affordable monthly payment.
For example, let’s say you’re looking for a $350,000 30-year fixed rate mortgage. If your credit score is 740 and you qualify for an interest rate of 6.5%, you will pay $2,212 per month (principal and interest only) and $446,583 in interest over the life of the loan . But if your credit score is 650 and the lender offers you a rate of 7.5%, your monthly payment increases to $2,447. Additionally, the interest you will pay for the term of the loan is $531,258.
There are general average interest rates for different FICO scores – or strictly speaking, FICO score ranges. (Of course, this can vary from lender to lender, and other factors beyond your credit score can also influence their decision). The average interest rates that loan applicants can qualify for, based on their FICO score, are as follows:
|620 to 639||7.97%|
Credit Score Basics
Before taking the next steps to improve or repair your credit, it’s essential to understand how your credit score is calculated. This helps you know which areas of your credit profile to focus on.
The FICO credit scoring model, which is used by 90% of creditors to make a loan decision, consists of five elements:
- Payment history: 35% of your credit score
- Amounts due: 30% of your credit score
- Length of credit history: 15% of your credit score
- Composition of credit: 10% of your credit score
- New credit: 10% of your credit score
Improve your credit score
There are several ways to improve your credit score before applying for a mortgage. The first step is to obtain a copy of your credit report from the three major credit bureaus: Experian, TransUnion and Equifax.
Review the reports and identify the negatives impacting your credit health, so you know what to focus on first. Also, dispute any errors you find with credit bureaus and creditors to have them rectified.
Below are some additional steps you can take to move your credit score in the right direction.
Reduce your debt
First: get out of debt.
- Pay all your bills on time. A single missed payment could drop your credit score by several points once the account is 30 days past due. Late payments stay on your credit report for seven years, but the negative impact diminishes over time.
- Update all your overdue accounts. If accounts are overdue, update them to avoid further adverse credit reports. You can also contact the creditor or lender and request a payment arrangement to return the account(s) to good standing.
- Reduce your revolving debt balances. The amount of charges you have on a credit card, relative to the overall line of credit, is called your credit utilization ratio or rate. For example, if you owe $15,000 on all your credit cards and the overall limit is $30,000, you have a credit utilization rate of 50%. Ideally, your credit card account balance should not exceed 30% of the card’s credit limit. So, using our example, you would want to reduce the total amount you owe to $9,000 or less to improve your credit score.
- Consider a debt consolidation loan. This type of debt instrument helps improve your credit utilization by consolidating your debts into one loan, preferably with a lower interest rate. You will also simplify the repayment process and could save a lot of interest.
Increase your credit
Reducing your debt is good, but you can also approach things the opposite way, by increasing your credit.
- Ask for higher credit limits. Some credit card companies allow you to request a credit limit increase without affecting your credit score. If approved, your credit utilization rate will decrease, assuming you refrain from making additional purchases with the card. A drop in your credit utilization rate could also mean good news for your credit score.
- Transfer balances. If you get an offer for a credit card that offers zero percent interest (usually for a fixed period, like 20 months), consider transferring the amount you owe to another card, especially if the old card has a high APR. Yes, you will temporarily lower your credit score, but you will also increase your credit utilization rate. In addition, it will be easier to pay off the old debt, since it will not generate interest. Just try to do it before the zero percent offer ends.
- Become an authorized user. Ask a relative or friend to add you to accounts with an outstanding payment history and low usage rate as an authorized user. The account will show up on your credit report and could boost your credit health.
Other strategies can fine-tune your credit score, especially closer to applying for a mortgage.
- Do not close old credit accounts. Even if you pay off balances, closing credit cards you’ve had for a while causes the average age of your credit accounts to drop, which could hurt your credit score. You could also have a negative impact on your credit utilization rate.
- Refrain from applying for new credit. Besides balance transfer offers, avoid signing up for new credit cards or taking out new loans of any kind. Each time you apply for credit, a firm credit application is generated, which could cause your credit score to drop slightly. Although the impact is temporary, mortgage lenders frown on consumers who open new credit accounts shortly before or during the application process.
Credit score minimums by loan type
Mortgage lenders use your average FICO score from the three major credit bureaus (Experian, TransUnion and Equifax). So, if your scores are 660, 680, and 710, 680 is the number that will be used to determine the loan terms you qualify for.
Different types of mortgages have different minimums. Here are the credit score minimums by loan type:
- Conventional loans: 620
- FHA Loans: 580 (with 3.5% down payment) or 500 (with 10% down payment)
- USDA loans: 640
- VA Loans: 620
- Giant Loans: 700
Keep in mind that some lenders have specific overlays or guidelines that are stricter than the lending rules set by the FHA, USDA, VA, Fannie Mae, and Freddie Mac.
Ideally, you want to aim for a credit score of 760 or higher to qualify for the best rate. But if your score is slightly lower, you can still get approved for a home loan on competitive terms.
You should take the necessary steps to improve your credit as long as possible before your home search. The longer you’ve had a good score, the better, as far as lenders go.
When you’re ready to apply for a mortgage, research lenders and get pre-approved with your best options to compare home loan deals. You might find that one has a much more competitive offer than the other, or that your credit score needs more work to qualify for better rates.
But if your credit is in good shape and the loan offers work for you, hire a reputable real estate agent to help you navigate the home buying process.