Home buyers who take the necessary steps to improve their credit scores prior to house hunting save significantly over the life of their loans, compared to buyers who wait to fix their scores until they’re ready to buy. Low credit scores negatively affect home buyers by reducing their available loan options and increasing their financial burdens. Home buyers who address credit concerns before they’re ready to purchase a home have the opportunity to clear flaws on their reports with time for their scores to rebound, avoiding the mortgage consequences when it comes time to buy.
How Do Credit Scores Affect Mortgages?
Potential home buyers should begin the house-hunting process by selecting a lender. Lenders evaluate borrowers’ financial histories to establish affordable mortgages, maximum loan amounts and appropriate interest rates for borrowers. When borrowers have pre-approval for a loan amount, they have clear direction to launch their house hunt on an affordable course.
In most circumstances, home buyers should work with the lender who offers the lowest interest rate. The lower the interest rate, the less expensive the mortgage is for the borrower over the life of the loan. Lenders use credit ratings to determine the interest rate the borrower pays on the loan.
What Are Mortgage Disadvantages of Poor Credit?
Having a bad credit score means a loan comes at a higher cost to the borrower. Home buyers who have a history of managing their credit poorly are more likely to default on their mortgages than buyers with an excellent credit history. Consequently, lower credit scores require lenders to absorb more risk. Therefore, borrowers with poor credit get quoted higher interest rates from lenders and end up paying more for loans than borrowers with good credit.
Another drawback for borrowers with poor credit is that fewer loan programs area available to them. Loan programs have set restrictions for borrowers’ debt-to-income ratios (DTI). Borrowers with excessive recurring monthly payments for their debts typically have higher DTI percentages. Generally, conventional loans require borrowers’ debts not to exceed 36 percent of their monthly gross income while FHA loans allow a maximum debt of 43 percent. It can be difficult for borrowers with poor credit and high debt to find lenders willing to loan them money. These borrowers may need to offer larger down payments to offset the risk to the lenders. Some lenders even require co-signers or additional paperwork to get a loan cleared by their underwriters.
When Should Borrowers Fix Poor Credit?
To avoid limited loan programs and high interest rates, borrowers should improve their credit scores before beginning the home-buying process. Correcting credit reports takes time. In general, fixing errors and issues on a credit report takes about three months, or 90 days. Therefore, people who are considering buying a home should begin repairing negative aspects of their credit reports at least three months prior to selecting a lender. It’s beneficial for prospective home buyers to correct past due collection accounts, dispute errors and pay at least the minimum balances on credit cards as soon as possible, because a borrower’s credit rating is commonly the most important financial information the lender uses to assign an interest rate.
How Will Poor Credit Affect Interest Rates?
Prospective home buyers who want to make sure their credit scores are aligned with low interest rates should consider these general credit guidelines. Credit scores range from 300 to 900. A score of 740 is the U.S. average, but a score of 850 is rare and exceptional. Lenders consider a 720 or above an excellent score, while scores of 660 to 719 are good credit scores. A fair score ranges between 620 and 659 while any score of 619 or less is considered poor credit. As a basic rule, prospective buyers can assume in a scenario where all factors are equal, with every 40-point reduction in credit score the interest rate offered by the lender could rise 0.25 percent. For instance, if a borrower with a credit score of 740 is offered an interest rate of 3.5 percent, then the same borrower with identical circumstances except a credit score of 700 can assume his interest rate might be 3.75 percent. Over a 30-year term, and dependent upon the loan amount, the borrower with lower credit might pay thousands of dollars more than the borrower with excellent credit.
How to Improve Your Credit?
One strategy for prospective home buyers to ensure they have good credit is to monitor their credit reports. Consumers have the right to access a free copy of their credit reports once per year without it penalizing their scores. AnnualCreditReport.com offers reports for the three major credit-reporting agencies: Equifax, TransUnion and Experian. Consumers should review their reports each year monitoring for inaccuracies, errors in Social Security numbers, account details, the spelling of names or even cases of identity theft. All of these mistakes can negatively affect credit scores, interest rates and mortgages.
Prospective home buyers should be extra responsible with their finances to protect their credit scores prior to purchase. One common sense option is to only spend on credit cards what can be paid back each month. It’s important to pay at least the minimum balance on time, but paying extra reduces debt faster and reflects positively on a credit report. Be sure to only use a small percentage of the available credit on an account at any time. It’s better to have a few accounts with low balances than one account where the majority of the balance is used. Conversely, it’s damaging to have numerous lines of credit or multiple inquires for new credit around the time when home buyers are seeking loans.
In conclusion, whether consumers are buying homes for the first time or refinancing, a higher credit score ensures a lower interest rate. Although unexpected collections notices may seem like irrelevant scams, it’s vital that future borrowers resolve mistakes and balances on their credit reports prior to seeking a loan if they want better mortgage options.
Tali Wee lives in Seattle where she handles community outreach for Zillow. She is captivated by, and appreciates everything real estate-related. Tali is also a new homeowner and enjoys spending time on projects around the house.