When my wife and I bought our first home (circa 1993), we had no idea what our FICO score was. Back in the day, you couldn’t simply fire up the computer and check your score. In fact, we applied for our mortgage over the phone, not over the Internet. My, how things have changed!
But one thing hasn’t changed—the importance of a good FICO score when it comes to getting a mortgage. Not only will a good score help you qualify for a home loan, but it will also help you get the lowest rate possible. If you plan on taking out a mortgage—which almost all homebuyers do—understanding how your credit score affects your mortgage rate can mean saving thousands of dollars over the life of the loan.
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When you take out a home loan, you of course have to pay interest on the money that you are borrowing. The amount of interest you pay on a fixed rate fully amortizing loan is a function of three things: 1) the amount you borrow; 2) the term of the loan; and 3) the interest rate, which is expressed as a percentage. The mortgage rate you receive depends heavily on your credit score. For this reason, let’s get a basic understanding of your credit score.
Each of the three major credit bureaus (Equifax, Experian, and TransUnion) collect information on you about your practices of borrowing and paying back credit. This is compiled into a credit report, from which a credit score is calculated. While there are multiple formulas for calculating credit scores, the formulas introduced by the Fair Isaac Corporation are the most widely used. When you hear the term FICO score, know that FICO is short for Fair Isaac Corporation. All these scores can be a bit confusing, so it might be useful just to think of “credit score” as a numeric grade of your credit history.
Lenders consider many factors like employment, salary, savings, and debt-to-income ratio when they determine your mortgage rate. However, your credit score is a key indicator of the rate you will likely receive. Fair Isaac Corporation looked at thousands of financial lenders to come up with the current mortgage rates provided to borrowers given their credit score. Let’s look at the credit rates for people with three different credit scores:
• Credit score of 620: 6.2 percent
• Credit score of 700: 4.8 percent
• Credit score of 780: 4.6 percent
Clearly, your credit score significantly impacts your mortgage rate. But let’s apply these scores to a real scenario to see how much a good credit score can save you and how much a bad credit score can cost you. Let’s say you are looking at a $250,000, 30-year fixed mortgage. If you have a credit score of 620, you are considered a riskier, subprime borrower. You will be making a monthly payment of principal and interest of $1,527, which amounts to $299,821 of total interest paid over thirty years.
If you have a better credit score of 700, you are considered a less risky, good borrower. You can expect to pay $1,313 monthly for a total of $222,689. If you have an extremely favorable credit score of 780, you fall into the top-tier range of borrowers, and lenders will very likely offer you a lower mortgage rate along with more loan choices. Your monthly payment will be $1,280 for a total of $210,681.
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As you can see, having a score of 780 instead of 700 does not make much of a difference in your mortgage payment. Over thirty years, the difference is about $12,000. However, having a credit score as low as 620 can cost you dearly. You will pay hundreds of dollars more each month and tens of thousands of dollars more over the lifetime of the loan. If you can improve your score, you can save tons of money. Specifically, if you raised your score from 620 to 700, you could save an extra $77,133. If you raised it even higher to 780, you could save $89,140.
Building a great credit score is extremely important to obtaining a good mortgage rate and saving boatloads of cash. Also, remember that although credit scores can reach as high as 850, you don’t need to worry too much about obtaining a perfect credit score. Fair Isaac Corporation suggests that lenders don’t differentiate much between someone having a score of 720 and someone having a score of 820. Once you reach that score of 720, you will likely receive the lowest mortgage rates available. Start small, improve your FICO score, and bask in the mortgage savings that you earned.
DR is the founder of the popular personal finance blog, the Dough Roller and credit card review site, Credit Card Offers IQ.
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