If you know a single thing about buying a home, you probably know that your credit score affects whether you qualify for a home loan. If you have terrible credit history – lots of missed payments, high credit card balances, public liens, bankruptcy, etc. – your chances of actually getting a mortgage are slim.
That's because lenders see your credit score as an indication of how well you'll pay your loan back and whether or not you'll pay on time regularly. You'll need a credit score of at least 580 for a home loan backed by the Federal Housing Administration, and you'll need a score of at least 620 to get a conventional mortgage loan.
But when it comes to credit for buying a home, higher really is better – even if you're already within the credit score range of being able to obtain a mortgage. Why? Because the higher your credit score, the better interest rate you can get. And the better interest rate you can get, the more home you can afford.
Credit Scores Affect Interest Rates
Your credit score affects more than just whether you'll qualify for a mortgage. Your score also determines the interest rate you'll receive. The reason is simple: The higher your credit score, the less risk you pose to lenders. And with the less risk, lenders are able to offer lower rates. Think of credit scores and mortgage rates as a sliding scale. The higher your credit score, the lower your interest rate.
According to myFICO.com's FICO score and interest rate chart, typical rates on a 30-year, fixed rate loan run anywhere from 4.082 percent for a credit score of 760 to 5.671 percent for a credit score of 620. (This chart changes daily, so current rates will vary.) That may seem like an incremental difference, but in the world of mortgages, 1.5 percent makes a big difference in monthly payments. And your monthly payments are directly related to how much home you can afford.
Interest Rates Affect What You Can Afford
Typically, lenders will let you take out a loan with payments that equal up to 28 percent of your total monthly income (though in some cases this ratio can be a bit higher). For example, if you make $6,000 a month, you could qualify for a mortgage with a monthly payment of up to $1,680 ($6,000 x 28 percent), inclusive of principal, interest, taxes and insurance (PITI). (There are other factors that go into qualifying for a mortgage, of course, but for our purposes we will focus just on this ratio.)
So how much home could you afford with a monthly payment of $1,680? It depends largely on the interest rate you receive. To see this in action, let's look at three examples.
First, let's start with the following assumptions about your homebuying situation:
• You can afford to pay $1,680 per month in PITI.
• You have saved a $20,000 down payment.
• You pay taxes and insurance of $336 a month.
We'll run three different scenarios based on myFICO.com's chart, which gives current interest rates for different credit score ranges.
Scenario 1: Low FICO of 620-639
With a relatively low FICO score (at least when it comes to applying for a mortgage) of 620-639, you could expect to pay 5.671 percent in interest. This would mean you could borrow up to about $232,299, giving you the power to purchase a home for about $252,299 once you add your down payment.
Scenario 2: Mid-range FICO of 660-679
In the middle of the pack with a FICO score of 660-689, you could expect to pay about 4.695 percent interest. This would let you borrow up to $259,291 for a total home price of $279,291.
Scenario 3: High FICO of 760-850
With this top-notch FICO score, you may qualify for a premium rate of just 4.082 percent. This would allow you to borrow up to $278,749 for a total home price of $298,749.
That's a nearly $50,000 difference between a low and high FICO score. Clearly, working on your credit score before applying for a mortgage is a worthwhile pursuit that could seriously expand your homebuying opportunities and save you a lot in interest payments over the life of the loan.
Rob Berger is the founder of the personal finance blog the Dough Roller.