When it comes to qualifying for a mortgage loan, underwriters will look very closely at three main areas – credit, income and down payment. A better understanding of the role your credit scores play in the mortgage process is a must. Not only for those who are, shall we say credit score-challenged, but also for those who think they have excellent credit. Much has changed in the world of mortgage lending – a 720 isn't what it used to be.
While the thought of finances can give many folks a headache and even seem like a hassle, not knowing your scores can cause you to overpay for your mortgage. By understanding your credit rating and what impacts your scores, you can proactively take a few easy steps to prevent future headaches when obtaining a mortgage.
Let's start with understanding the credit scoring system used by mortgage companies. Lenders use a scoring system known as the FICO model. FICO stands for Fair Isaac Corporation. Invented in the 1950's, FICO has become the standard for rating homebuyer credit. Anecdotally, there are many people who refer to their credit scores as their "FICO scores". However, just like when people interchange the word Xerox with photo copy, FICO is the model or brand, not the product.
The three bureaus used in the United States are Equifax, TransUnion and Experian. FICO credit scores generally range from 300-850. Average credit scores for the majority of Americans range between the high 600's to the low 700's.
What makes up your FICO score? A lot actually. The primary factors can be narrowed down to five categories.
- Payment History – 35%
- Amounts Owed – 30%
- Length of Credit History – 15%
- New Credit – 10%
- Types of Credit Used – 10%
For more details on each category, click here.
Because lower scores usually mean higher mortgage defaults, someone with lower scores will likely receive a higher rate and/or pay higher costs. To get the most favorable interest rates at the lowest costs, "excellent" scores are needed. Excellent scores typically come in the form of 740 or higher. When credit scores are below 700, the extra fees (also known as discount points) can add up quickly. A person with a 695 credit score can pay as much as 1.5 points higher than the person with the 740. That's $1,500 for every $1,000 borrowed! Granted, the borrower may choose to trade in the cost for a higher rate but either way, the end result is paying more because of lower scores.