How to Understand Your Credit History and Credit Score
Credit history and score are two of the most important consideration factors that lenders use to approve or deny their loan applications. But, this is not to say that someone with imperfect credit can’t get approved for a mortgage. In some cases, a borrower with imperfect credit may be offered a loan, but one with a higher interest rate, or the lender may require more money down, or advise the borrower to purchase a less expensive home. In this section of the guide, we will go over:
- Can I Buy a Home with Bad or No Credit?
- What Kind of Credit Score Do I Need to Buy a Home?
- How to Fix Your Credit Score to Buy a Home?
Can I Buy a Home With Bad or No Credit?
In the world of mortgage loan approvals, the higher the credit score, the better. A high credit score helps ensure that the borrower gets the lowest interest rate on their home loan while a borrower with fair credit or worse may find it especially challenging to get approved.
Here is how your credit score can affect your interest rates and approval odds.
- Exceptional Credit (760+): Having a top-tier credit score will enable you to take advantage of the best rate available at the time.
- Excellent Credit (720-759): This type of credit will only impact your interest rate slightly, usually no more than 0.25% higher than the lowest rate.
- Good Credit (680-719): Good credit will affect your interest rate a little more. Typically, borrowers with good credit are offered loans with interest rates approximately 0.5% higher than the lowest rate.
- Fair Credit (620-679): This is where the divide widens in relation to interest rate. Borrowers with moderate credit can expect to pay 1.5% higher interest than the lowest rate available.
- Poor Credit (580-619): It’s not impossible to get approved for a mortgage with poor credit, but borrowers can expect their score to cause them to pay rates anywhere from 2% to 4% higher than the lowest rate.
- Bad Credit (350-579): It’s a steep uphill climb, but some borrowers are still able to get approved with very poor credit, however, the interest rate they are going to get will be extremely high.
The ideal credit score for applying for a mortgage is 700 or above. While it is still possible to get approved with a score less than 700, the interest rate for borrowers with lower scores will start impacting the overall cost of owning a home.
If the borrower doesn’t have any established credit, the lender will require them to provide another means of creditworthiness. In most cases, the lender will want to see the borrower’s history of paying their utility bills, cable bills, phone bills, and other monthly expenses. So, while it is possible for someone to get approved for a mortgage with no established credit, it is more challenging than it will be for a person with an established credit history.
What Kind of Credit Score Do I Need to Buy a Home?
Different types of home loans have different credit requirements. For instance, for a conventional loan, the minimum FICO score for approval is 620. FHA loans are a little more lenient, but they also have limitations. The lowest credit score a borrower can have and still get approved for an FHA loan is 580. VA and USDA loans don’t have set minimums, but rarely are mortgages approved for applicants with credit scores lower than 580 in either case.
The average credit score for buying a house is 600 or above, so this means even an applicant with bad credit can get financed.
If you have imperfect credit, but you want to buy a home, all is not lost. Get copies of your credit reports and review them for inaccuracies. Simply disputing an incorrect piece of information can help raise your number once the negative information is removed. Once you have your score as high as it can go, get prequalified by your lender. This will tell you how much home you can afford, and it will also show sellers that you’re serious about buying.
Keep in mind that when you get prequalified, it is not necessarily a loan guarantee. Your credit score and history must remain the same or improve between the prequalification and the loan approval. Do not apply for new lines of credit or allow any of your accounts to go delinquent, or the prequalification will mean nothing.
How to Fix Your Credit Score to Buy a Home
When a lender reviews your credit, they are looking for certain factors, but some factors are more important than others. Knowing what lenders are looking for will help you to concentrate on the most important parts of your credit profile. Here’s a breakdown of what lenders look to most when deciding on a loan approval.
- Payment History (35%)
- Credit Utilization (30%)
- Age of Credit (15%)
- Different Type of Credit (10%)
- Number of Credit Inquiries (10%)
Because payment history is so important to lenders, you need to ensure that you do not miss any payments on your debt obligations. One way you can do this is by setting payment reminders for yourself through your bank. Or, you can arrange for your bills to be paid automatically from your bank account. If you choose this direction, schedule your payments to be made a few days before the due date to ensure the payment gets made on time and without error.
Another way to improve your credit is to reduce the amount of debt you owe. To accomplish this, you should stop using your credit cards. Next, you should review the interest rates for all of your credit cards and create a budget that allows you to pay more on the card with the highest rate. Once that card is paid off, start applying the extra money to the next card with the highest interest rate. By tackling your debt this way, you’ll save money and improve your credit steadily over time.
If you have missed payments in the past, then concentrate on getting your accounts current and keeping them current. The impact of those missed payments will soften the older they get.
Additional credit improving tips include:
- Keep the balances on revolving credit accounts as low as possible
- Pay off debt instead of moving it from card to card
- Do not apply for new credit cards if you do not need them just to increase your available credit
- Do not close paid or unused credit card accounts, because the older the accounts are, the higher they will make your credit score
Ruining one’s credit can happen overnight, but fixing it takes time. If your credit score is keeping you from getting approved for a mortgage, then focus your energy on improving it. Eventually, you will get where you need to be.
Not all mortgages are the same. There are numerous factors that can impact everything from one’s monthly payment amount to their interest rate. In this section, we will provide you with the most common components you will have to consider when applying for a mortgage, including:
- Type of Rate / Rate Features
- Down Payment
- Points and Interest Rates
Type of Rate / Rate Features
Most borrowers will have to choose between two different types of rates for their mortgages – a fixed rate or an adjustable rate mortgage (ARM). There are advantages and disadvantages to both, so knowing what to expect is important for being able to confidently choose a mortgage rate.
Fixed Rate Mortgages
A fixed rate mortgage is one in which the interest rate remains the same throughout the life of the loan. This is the most popular type of rate among American homeowners because most families prefer having the same mortgage payment month after month. A fixed rate mortgage enables the buyer to easily incorporate their monthly payment into their budget because it doesn’t change. Its simplicity is also why this type of rate is especially a favored choice among first-time homebuyers.
However, as popular as fixed rate mortgages are, they are not perfect. The disadvantages of this type of rate need to be considered before making the final decision. For instance, fixed rate mortgages are almost always sold by lenders on the secondary market. This means that this type of mortgage cannot be customized to the borrower like an ARM can. They can also prove to be more expensive for some borrowers because fixed rate mortgages lack the benefit of early-on payments and rate breaks.
Another thing to consider is that should the national interest rate sharply decline, a fixed rate mortgage would need to be completely refinanced in order to take advantage of the lower rate. This process will typically cost thousands of dollars in closing costs and a lot of time spent going through the process of refinancing the home.
Adjustable Rate Mortgages
An adjustable rate mortgage is one in which the interest rate on the loan changes when it goes through an adjustment period. This type of rate is popular among those who do not intend to remain in the home for longer than a few years, as well as investors and “flippers.” Over the course of an adjustable rate mortgage, the loan will have an initial rate and period followed by an adjustment rate and period. Here’s an example:
If a lender offers a borrower a 5/1 LIBOR ARM at 3.25% with 2/2/5 caps, the rate on the loan will remain at 3.25% for the first five years. After the first five years, an adjustment can be made on the rate once a year. The 2/2/5 caps include the following:
- 2% is the maximum percent change allowed for the first adjustment (up or down)
- 2% is the maximum adjustment allowed each time the rate adjusts (up or down)
- 5% is the maximum adjustment allowed overall, meaning the highest interest allowed on this loan would be 8.25%
Most adjustable rate mortgages are initiated with lower interest rates than the average fixed rate mortgages. Because of the lower initial interest, an ARM makes it possible for a borrower to afford a larger home. There’s always the chance that the national interest rate could decline over the life of the loan, thus enabling the buyer to take advantage of the lower rate without having to refinance.
Of course, the other side of the coin is that should interest rates climb quickly, that 3.25% rate could become 8.25% just five years into the loan. ARMs are also much more complex than fixed rate mortgages with all of the customization, caps, adjustment indexes, and other features available. This means an inexperienced first time buyer could be easily confused by their loan, or worse, could be taken advantage of by a less-than-honest mortgage company.
Before selecting either type of mortgage, it is important to check for certain risky loan features, like balloon payments and prepayment penalties.
How to Know What Risky Loan Features to Look For?
A mortgage that’s known as a balloon loan is one in which the borrower pays just the interest on the loan for the first few years. While this may be attractive to buyers because the initial payments are so much lower, the reality is that the lender will want the entire principal of the loan to be paid in one lump sum, usually within three to seven years after the loan was originated. This means the borrower will have to pay the entire loan off at that time, hence the term “balloon payment.”
Most lenders allow their borrowers to pay off as much as 20% of their mortgage each year. But, some borrowers pay off more than 20% of their mortgage in one year, such as in cases where the home is sold or refinanced, and in these cases it is known as a “prepayment.” Some lenders have language in their agreements that allow them to penalize the borrower should they sell, refinance, or pay more than 20% of their loan in one year. Prepayment penalties are typically listed in the agreement as either “soft” or “hard” penalties. A soft penalty permits the borrower to sell their home at any time, but the borrower will be penalized should they refinance. A hard penalty will penalize the borrower if they sell OR refinance their home. The amount of the prepayment penalty is usually 80% of six months’ interest on the loan. So, if a homeowner has a $500,000 loan with an interest rate of 6.5% and a monthly payment of $2,708.33, their prepayment penalty will be 80% of six months’ of payments ($16,249.99), which equals approximately $13,000.
How to Understand Mortgage Down Payments
The amount of money that is paid upfront on a mortgage is called the down payment. This amount of money impacts everything from a borrower’s loan approval chances to how much home they can afford to how much their monthly mortgage payment will be. Therefore, more is always better when it comes to the down payment. This portion of the guide will provide you with everything you need to know about the down payment.
What Is the Average Down Payment?
The size of a down payment varies, but lenders typically require at least 20% of the selling price to be put down on the home in order for the borrower to get the best interest rate on their loan. By putting at least 20% down, the borrower will also be able to avoid having Private Mortgage Insurance (PMI) on their loan.
Private Mortgage Insurance is required on any conventional loan in which the borrower puts between 5% and 19% down on their home. This insurance protects the lender in the event the buyer stops making their loan payments.
If a borrower is unable to put at least 5% down on their home, then there are other options they can still pursue. An FHA loan is one of the most popular options in these cases because this type of home loan only requires the borrower to put 3.5% down. There are also some loans in which the borrower can obtain a mortgage with no money down.
No Down Payment Loans (VA and USDA)
If the borrower is active-duty or a veteran of the U.S. Armed Forces, then they may be able to qualify for a home loan with no money down by getting a VA loan. VA loans also don’t require the homebuyer to pay monthly Private Mortgage Insurance. Additional benefits of VA loans include:
- No prepayment penalties
- The seller can pay all of the buyer’s loan-related closing costs and up to 4% in concessions
- Lower interest rates than conventional and FHA loans (3.625% VA 30-year fixed vs. 3.875% conventional 30-year fixed)
- VA mortgages are assumable
- Foreclosure avoidance advocacy
To be eligible for a VA loan, the applicant needs to meet the requirements set by the Department of Veterans Affairs. However, because the VA does not originate the loan, the borrower will still have to meet the requirements of the lender they use to obtain financing. The VA’s eligibility requirements include:
- Borrower must be active duty or a veteran who has available Certificate of Eligibility (COE)
- Loan must be used for an eligible purpose
- Borrower must have satisfactory credit (usually 620 or above)
- Debt-to-Income ratio of 41% or lower
- Borrower must intend on living in the home for a reasonable period of time after closing
- The income of the veteran and spouse must be sufficient and stable to meet the mortgage payments, as well as the cost of living and debt obligations
What Do You Qualify For?
Finding out how much of a VA loan you can qualify is easy. Just use our mortgage payment calculator. Then, to get started on your application, contact your local Veterans United Loan Specialist.
USDA loans are similar to VA loans in that they are zero-down loans, but they are designed specifically for the buyer who is buying an eligible rural or suburban home. USDA loans are issued through the United States Department of Agriculture loan program, also known as the USDA Rural Development Guaranteed Housing Loan Program. As similar as USDA loans are to VA loans, the former still requires the borrower to pay mortgage insurance if they don’t put any money down.
There are three different types of USDA loans available – guaranteed loans, direct loans, and home improvement loans and grants.
- Guaranteed Loans: This type of USDA loan is guaranteed by the USDA but not issued by it. A guaranteed loan needs to be obtained through a lender who participates in the program.
- Direct Loans: This type of loan is issued by the USDA. They are typically reserved for low- and very low-income applicants. With subsidies, interest rates for USDA loans can be as low as 1%.
- Home Improvement Loans and Grants: Home improvement loans or grant awards are ideal for homeowners who want to repair or upgrade their homes. The USDA program also offers packages can combine a loan and a grant, providing up to $27,500 in assistance.
Prepayment Options to Reduce Down Payment
If a borrower is unable to put at least 20% down on their home, they can still save money by prepaying their mortgage. Prepayment is essentially paying more every month than the minimum payment. By making larger payments, the loan gets paid off quicker, and as a result, the homeowner will potentially save thousands of dollars in interest. The homeowner will also build equity in their home faster by prepaying than just paying the monthly minimum.
Of course, before a homeowner starts prepaying their mortgage, they need to read their contract agreement carefully. Some lenders charge a prepayment penalty if more than 20% of the amount of the loan is paid back in one year’s time.
Do You Have Accessible Cash for a Down Payment?
Lenders always look to see where the money being put down on a home came from. With conventional mortgages, all of the money being put down needs to come from accessible cash via the borrower’s checking or savings accounts. FHA loans are more lenient in that they allow the borrower to use “gift” money for their down payments. An example of this would be if the borrower’s parents gave them the money. Or, if the homebuyer is eligible, they may be able to get a mortgage with no money down through the VA or USDA.
If the borrower is going to use a conventional mortgage, then they will be required to put at least 20% of the selling price down. So, how much money will be needed will be determined by how much the home is being purchased for. For instance, if the home is being sold for $250,000, then the minimum down payment for this type of loan is going to be $50,000. Or, if the borrower is going to go with an FHA loan, then the minimum they would have to come up for the same home would be $8,750.
Before a borrower can truly determine if they can afford the home they’re interested in, they need to take into account the average utility costs for a home of that size. They also need to add in any HOA costs or condo fees. A home that looks easily affordable can quickly become overwhelming if these expenses and all of the borrower’s other monthly debt obligations aren’t figured into the equation.
It is also important to note that the down payment isn’t the only money a buyer needs at the closing. There are other upfront costs the buyer will also need to take care of, including:
- Home Inspection ($300-$500)
- Survey Costs
- Property Taxes
- Closing Costs (2% to 5% of the purchase price)
- Cash Reserves (2 to 6 months’ of mortgage payments)
Points and Interest Rates
Points are fees that a buyer can pay directly to the lender at the closing in exchange for a lower interest rate on their loan. This is a popular way for a homebuyer to reduce their monthly mortgage payment. One point costs 1% of the loan amount and the money essentially goes toward prepaying some of the interest on the loan.
While points are usually paid by the buyer, in some cases, a buyer may negotiate for the seller to pay points in order for the sale to go through. This money is typically used to cover some or all of the closing costs.
When Does It Make Sense to Pay Points?
It is most beneficial to pay points in cases where the buyer is purchasing a long-term mortgage. By paying points, the buyer can reduce their loan payments and actually save money over the life of the loan. Here are two examples:
- A homebuyer takes out a $200,000 mortgage. If the buyer pays one point ($2,000), they will get an interest rate that’s lower by 0.25% and a monthly payment that is approximately $30 less per month. Over the life of the loan, they will save $10,616.40 versus paying no points.
- Using the same mortgage, if the buyer pays two points ($4,000), they will have an interest rate that’s 0.5% lower and a monthly payment that’s nearly $59 less. Over the life of the loan, the savings will be more than $21,000.
Another situation where paying points can be beneficial is when the buyer can comfortably afford their mortgage payment as it is. In this case, the buyer can negotiate the seller to pay points so their closing costs can be reduced.
Understanding Interest Rate Tables
For many homebuyers, the mortgage interest rate table is a confusing mix of numbers. But, it’s easy to understand if you know how to read it. The typical interest rate table is comprised of one column featuring the interest rates, and two other columns – one for 15-year terms and another for 30-year terms. Each of these feature two columns of their own – monthly payment factor and total amount.
To determine how the interest rate impacts the amount that is paid on a loan, find the interest rate and the monthly payment factor on its same line for the type of mortgage you’re interested in. Take the monthly payment factor and multiply it by 100. Take that figure and multiply it by 12. Then, take that number and multiply it by either 15 or 30 depending on the term of the loan. The answer is what you can expect your payment to be with that interest rate.