Would you lend a stranger $249,500? Would you trust that person to repay the entire amount, plus interest? Would you trust that person to pay it all back within 30 years? Those are the questions that mortgage lenders have to ask themselves when deciding whether or not to approve a mortgage loan.
$300,000 is the median home price in the United States, as of early 2019. On average, that’s about how much it’ll cost you to buy a single-family home or condo. Most people don’t have that kind of cash sitting in their pocket, so they take out a mortgage loan from a bank, credit union, or other financial institution. A credit score is used by those lenders to determine the likelihood that the borrower will successfully repay the loan. There are several different ways you can get a credit score check.
Most lenders require a minimum credit score of 620 for a conventional mortgage loan. That’s the benchmark, but oftentimes it’s more of a guideline than a rule. If you’re applying for a guaranteed loan, or if you’re a first-time home buyer, you may get approved for a mortgage with a credit score that’s less than 620.
Here’s a comprehensive look at how your credit score affects your mortgage:
- Credit Score Basics
- What’s the Minimum Credit Score Needed for a Mortgage?
- Typical Credit Scores by Mortgage Type
- How Your Credit Score Affects Your Mortgage Rate
- Mortgage Rates by Credit Score
- What Else Determines Your Mortgage Rate?
- What’s the Minimum Credit Score Needed for a First-Time Home Buyer?
- How Can I Improve My Credit Score?
Credit Score Basics
Let’s briefly review what a credit score is and how it’s determined.
A credit score evaluates your creditworthiness. In other words, it determines how likely you are to repay a loan.
A high credit score suggests that there’s a strong likelihood you’ll repay your loan in full and that you’ll make payments on time. A low credit score suggests that you’re less likely to pay off your debt in a timely manner and that you may be at risk of defaulting on your loan.
Of course, you could have a high credit score and still default on a loan. You could also have a low credit score and still succeed in paying off your debt responsibly. A credit score isn’t a prophecy. But you have to understand why they’re important to lenders. Recall those questions we posed at the beginning of this post. It would be tremendously irresponsible to loan someone a large sum of money without first examining that person’s debt history. Credit scores help lenders determine who’s safe to loan money to.
The Three Credit Bureaus
There are three major credit reporting agencies in the United States that provide credit scores for consumers: Equifax, Experian, and TransUnion. They’re considered the “Big Three” credit reporting agencies. Every year, you’re entitled to receive one free credit report from one of the three bureaus. It’s a right that’s guaranteed by the federal government.
The three credit bureaus can determine your credit score by using either the FICO or VantageScore scoring models.
The FICO Score
The FICO score was the first major credit scoring system used in the United States. The system was designed by a company named Fair, Isaac, and Company (FICO). It’s one of the most commonly used credit scoring models.
In 2006, the three credit bureaus created their own scoring system: VantageScore. VantageScore evaluates the same financial data that FICO does, but it weighs the data differently.
FICO vs. VantageScore
What’s better: FICO or VantageScore?
Each scoring model is better suited for different purposes. To get a FICO score, you must have an account that’s been open for at least 6 months. The account must have reported to one of the credit bureaus within the last 6 months. You don’t need to meet those requirements to get a VantageScore score.
At Turbo, we use VantageScore. We think that VantageScore is better for consumers. It can provide scores for people who are new to credit or who use credit infrequently.
How is My Credit Score Calculated?
- Payment history (extremely influential)
- Age and type of credit (highly influential)
- Percentage of credit limit used (highly influential)
- Total balances and debt (moderately influential)
- Recent credit behavior and inquiries (less influential)
- Available credit (less influential)
Read our guide, “How to Raise Credit Score Numbers for a Healthy Score” for a more detailed overview of these categories.
What’s the Minimum Credit Score Needed for a Mortgage?
There’s no official minimum credit score for a conventional mortgage loan. However, most lenders prefer you have a credit score of at least 600 or 620 to qualify for a mortgage.
You should try and earn as high of a credit score as possible. The higher your credit score, the lower your mortgage rate may be. Most people spend over a decade paying off their mortgage loan, so the mortgage rate could potentially add thousands of dollars to a home cost. That’s why it’s important to obtain the lowest rate you can get.
The lender uses a variety of different factors to determine your mortgage rate. Your credit score is one of the most influential factors. But your rate is also dependent on the type of loan that you’re borrowing.
Typical Credit Scores by Mortgage Type
The minimum credit score you need to take out a mortgage is dependent on the type of loan that you get. Conventional mortgage loans, VA loans, and USDA loans typically require a minimum credit score of 620 or 640. FHA loans require a minimum credit score of 580.
A conventional loan is the most commonly borrowed mortgage loan. A conventional loan is not federally guaranteed. That means that the government does not insure the loan. If you default on the mortgage, the lender has no guarantee that they’ll get the money back that they loaned you. We’ll talk about federally-insured loans next.
A conventional loan typically requires a minimum credit score of 620. But because the loan isn’t guaranteed, the qualifications to get approved for one are sometimes more difficult. Lenders will make sure you’re financially stable and they might pour over your personal finances.
It’s recommended that you make a down payment of 20%. However, if your credit score is high enough (around 740), some lenders may permit you to make a down payment as low as 3%.
Conventional loans are usually associated with high out-of-pocket costs, such origination fees, appraisal fees, and mortgage insurance costs. But if you have a high credit score and make a sizeable down payment, you could receive one of the best possible mortgage rates.
Federally-insured loans are loans that are guaranteed by the federal government. That means that if you default on your loan, the government will pay back the outstanding balance to the lender. Guaranteed loans make it possible for people with low credit scores to get approved for a mortgage, and also those people who can’t make a large down payment.
It’s important to remember that guaranteed loans were not designed to protect you. They were designed to protect the lender. If you defaulted on your loan, you wouldn’t have to pay back the remaining balance. But you’d still lose ownership of the house and your credit score could be damaged significantly.
Nonetheless, a federally-insured loan is a great option if you’re financially capable of buying a house, but you’re hindered by short credit history.
The Federal Housing Administration (FHA) guarantees a loan that’s known as an FHA Loan. FHA loans have become very popular with low-income home buyers and first-time home buyers—millennials in particular.
An FHA loan has lower closing costs than a conventional loan does. It typically requires a down payment of 3.5%. The down payment can be funded by “gifts.” That’s exactly what it sounds like. If you receive money as a gift, you may be able to use it to make your down payment. According to the U.S. Department of Housing and Urban Development, the gift donor may be:
- The borrower’s relative
- The borrower’s employer or labor union
- A close friend with clearly defined interest in the borrower
- A charitable organization
- A governmental agency or public entity that’s providing homeownership assistance to first time buyers or low-income buyers
Younger home buyers may benefit the most from being able to use a gift. They might have older relatives who are interested in supporting their financial success, and who may be willing to contribute funds.
You need a minimum credit score of 580 to get an FHA Loan.
The U.S. Department of Veteran Affairs guarantees mortgage loans for military veterans and some military spouses. It’s called the VA Loan.
In most locations, the VA Loan finances up to $424,100 of any home. In areas where housing is more expensive (like California or New York), the VA Loan may finance more. VA Loans do get a little bit complicated when it comes to military spouses, or when a veteran includes a non-veteran in the mortgage. Read this article on VA co-borrowing for more information.
There is no minimum credit score for a VA Loan. However, it’s up to lenders to review the loan profile and make a determination on creditworthiness. Some lenders, like Veterans United, require a minimum credit score of 620.
The U.S. Department of Agriculture offers a “rural development” loan for those who are going to buy a home in a rural area. It’s commonly called the USDA Loan.
No down payment is required for a USDA Loan, but you will need to pay a 3.5% guarantee fee. However, the guarantee fee can be worked into the loan balance. Minimum credit scores range between 600 and 640.
You can use the USDA website to determine whether you’re buying a home in an eligible rural area. Don’t assume that these locations are only in isolated areas. Some areas are located in small cities that have agricultural industries.
How Your Credit Score Affects Your Mortgage Rate
Your credit score doesn’t only determine whether or not you get approved for a mortgage—it also influences your mortgage rate. If you have a good credit score, you’re more likely to receive a lower mortgage rate. If you have a poor credit score, you’re more likely to receive a higher mortgage rate.
Why does a credit score affect your mortgage rate?
Lenders will increase the cost of your mortgage for every risk associated with you. The lower your credit score, the more likely it is you’ll default on your loan. In the event that you default, the lender would want to collect as much money from you as possible beforehand, hence the higher rate.
Securing a good rate on your mortgage is very important. It might not seem like there’s a big difference between a 3.7% mortgage and a 4.3% mortgage. But, depending on the loan conditions, the 4.3% rate could cost you thousands (or tens of thousands) of extra dollars by the time you pay off the loan. That’s why maintaining a high credit score is important. A good credit score could help you reduce your monthly mortgage payments and save you heaps of money in the long-run.
Most borrowers pay off their mortgage over 30 years. A few percentage points could make a substantial difference in cost over three decades.
Mortgage Rates by Credit Score
How do mortgage rates vary by credit score? Let’s take a look at some average credit score statistics.
Analysts at Realtor.com processed 170,000 mortgage loans between Sept. 1 and November 7 in 2016. Here are the median mortgage rates for three ranges of credit scores:
- 725-850: 3.62
- 650-725: 3.75
- 625-650: 3.88
The rates are interesting, maybe even surprising to some. From the minimum required scores to get a mortgage, to the highest possible credit scores, there’s only a difference of 0.26%.
On the other hand, here are the rates for the most expensive loans in the same study:
- 750-850: 3.88
- 725-750: 4.00
- 700-725: 4.12
- 675-700: 4.25
- 650-675: 4.38
- 625-650: 4.50
These changes are much more significant.
The data sets show that while your credit score can significantly affect your mortgage rate, the credit score is not the only determinant of your rate. If you’re trying to get the most favorable mortgage loan, you should also be aware of the other factors that may influence your rate.
What Else Determines Your Mortgage Rate?
Lenders use your credit score and your loan type to determine your mortgage rate. Here are the other factors lenders use.
1. Home Location
Your mortgage rate may be affected by the location of the home you’re buying.
There are several reasons for this. First, mortgage rates are tied to the health of the local economy. If you’re buying a home in a healthy real estate market, lenders may believe that your risk of default is lesser. You’re more likely to receive lower mortgage rates. Conversely, if you’re buying a home where the local market is weak, lenders may believe you’re more at risk of default. You’re likely to receive higher rates.
Mortgage rates can also be influenced by state laws. Some states, for instance, require lenders to go to court when a borrower defaults on a loan. This is costly for the lender, and it may cause the lender to raise its mortgage rates in that state.
Local competition can also affect mortgage rates. If you’re buying a home in an area where there are lots of competing lenders, this may cause the lenders to offer competitive rates.
2. Loan Size
Mortgage rates tend to be higher when the loan is costlier. That’s because there’s more money at stake if the house forecloses, so lenders raise rates to compensate for the risk.
3. Down Payment
A large down payment usually results in a lower mortgage rate. When you make a large down payment, you have more stake in the home up-front. Lenders usually see that as a lower level of risk. You might need a down payment of at least 20% to receive a lower rate. If you place a down payment of less than 20%, you might be required by the lender to purchase mortgage insurance. Be advised that mortgage insurance will add to your monthly mortgage payments.
4. Loan Term
Your mortgage rate might be affected by whether or not your loan is a short term loan or a long term loan. Short term loans are usually paid off in 10 to 15 years. Long term loans are typically paid off no sooner than 30 years. Short term loans usually have lower mortgage rates; the caveat is that the monthly payments tend to be higher.
5. Interest Rate Type
There are two types of interest rates: a fixed rate and an adjustable-rate (sometimes called a variable rate).
If you take out a fixed-rate mortgage loan, it means that the mortgage rate won’t adjust over the life of the loan. Your mortgage rate, in the beginning, will be your mortgage rate in the end. Fixed rates are good because they allow the borrower to budget for the exact cost of their monthly payments. The downside to a fixed-rate mortgage is that if you take out a mortgage when the rates are higher, you’ll be stuck with that higher rate for the duration of your payments.
If you take out a mortgage with an adjustable rate, the rate can increase over the life of the loan. Usually, the rate is fixed at a very low percentage for the first several years. Afterward, it slowly increases. Although the rate has a ceiling that it’s not permitted to rise over, it’s not uncommon for the rate to nearly double over the life of the loan. The advantage of an adjustable rate loan is that the rate may be extremely low at the beginning. If you’re struggling with closing costs or if you’re struggling to make a down payment, an adjustable rate could be a good option.
6. Discount Points
Borrowers can purchase discount points to lower their rate. Of course, by paying discount points, you’d pay more money up-front. But a lower mortgage rate could save you a lot of money over a 10- to 30-year mortgage.
The opposite is possible, too. The lender could offer you lender credits, which would raise your mortgage rate but lower your closing costs. Borrowers must decide whether they’d prefer to pay more up-front or over the long term.
What’s the Minimum Credit Score for First-Time Home Buyers?
First-time home buyers tend to be younger, and so they usually have lower credit scores because their credit history is shorter. Still, most lenders prefer that first-time home-buyers have a minimum credit score of 620 or 640. Remember that you only need a credit score of 580 when you’re insured by an FHA Loan.
How Can I Improve My Credit Score?
For conventional loans, VA loans, and USDA loans, it’s recommended that you have a minimum credit score between 600 and 640. It might be difficult for you to get approved for a mortgage if your credit score is less than 600. An FHA Loan, on the other hand, only requires a minimum score of 580.
Always try and maintain the highest possible credit score so you can secure the best mortgage rates. While your credit score isn’t the only factor that’ll influence your rate, it’s a factor that’s heavily weighted by lenders.
If you need to boost your credit score, consider using a credit monitoring service like Turbo. We can provide you with an Intuit Turbo credit score sourced from TransUnion Vantage Score, and we can help craft a credit strategy so you can boost your score before you apply for a mortgage.