How much does credit matter when you apply for a home mortgage? People say, “I make plenty of money, is a low credit score really that big of a deal?”
If you’re struggling with credit, you may have a mountain of debt that looks impossible to deal with. You might wonder if it’s worth it to try, or if you can talk a lender into looking the other way and qualifying you based on your income. The truth is, low credit will cost you thousands of dollars, both when you make your down payment and throughout the life of your loan.
People also ask our credit experts what credit score they need to qualify for a home loan. We’ve written an article that answers that question in-depth, but the short answer is, you want your credit score to be as high as possible. Here’s why credit is such a big deal when it comes to buying a home.
Your Income Isn’t Part of Your Credit Score
Your credit score is a three-digit number calculated by looking at all the money you’ve ever borrowed and all the payments you’ve made. Lenders look at how much money you make to decide how much you can borrow, but your income isn’t part of your credit score.
Often buyers look at how much money they bring in every month and reason that their high salary means there’s plenty available for a house payment. There are a lot of pieces involved in borrowing money to buy a home. Your income is one of them, but your credit score is a separate component. Here are the five components credit bureaus use to calculate that number:
- Payment history – 35 percent of your credit score has to do with whether or not you pay your monthly bills on time, every time.
- Credit utilization ratio – Another 30 percent of your credit score is how much of the available credit you use on a monthly basis. If you max out all your credit cards, that hurts your credit score. If you only borrow a little and always pay it off in full, your score goes up.
- Length of credit history – If you’ve been borrowing money and paying it back on time for years, lenders assume you’ll keep doing so. That makes you a good risk. If you’re new at borrowing, you don’t have enough of a track record for them to trust you with their money.
- Types of credit used – Lenders like when individuals have (and regularly pay off) several different types of loans. If you make timely payments on your credit card, car payment, student loan and gas card, that helps your credit score.
- New credit – If you open several new accounts at once or have multiple credit inquiries, it can hurt your score.
It’s not personal. All credit bureaus do is gather data, use a formula to calculate your score and sell that score to lenders when you authorize a credit check. Most of the information comes from your current loans, and the rest is from public records. If you’ve filed for bankruptcy or been through a foreclosure, the credit bureaus receive that information about you.
But they don’t know the amount of your weekly or monthly paycheck. If you lose your job or get a raise your credit score doesn’t change, because it’s calculated based on what you borrow and how you pay it back.
Low Credit Means You’ll Pay Higher Interest
For most people, your home is the biggest purchase you’ll ever make. You borrow a high dollar amount and take 30 years to pay it back. Lenders make money by charging interest, the amount you pay for the privilege of borrowing from them. If you have a low credit score, lenders assume it’s a bigger risk to lend to you.
If you have trouble paying your car note or credit card payment on time, they reason you’ll probably also be late on your home mortgage payment. During that time frame, they’ll have less to lend to other borrowers. They might have to expend manpower to hassle you before you get around to making your payment.
If you have defaulted on other debt, you’re an even bigger risk. That signals you can’t always come up with the funds to pay what you owe. Lenders worry they might loan you thousands and later get stuck with the note.
If you have poor credit, you may still be able to get a bank or other lender to give you a home loan, but they’ll charge a higher interest rate. You pay more to borrow the same amount.
Calculating the Cost
Everybody pays interest when they get a home loan, so is there really that big of a difference? Let’s say when you buy a home, you finance $200,000. Like most people, you get a 30-year mortgage. If you have pretty good credit, you might borrow that money at 3.75 percent interest. If you do, your monthly payment just on the principal (not taxes, homeowner’s insurance or PMI) is $926.23.
Over the lifetime of your loan, you pay $133,443.23 in interest.
Let’s compare that to someone with a credit score between 620 and 639. They qualify for a home loan at 5.48 percent interest. Their monthly payment goes up to $1,133.07 plus taxes, homeowner’s insurance and private mortgage insurance.
They pay $207,905.06 total interest on their loan.
They pay $206.84 more every single month for the same house. Over the term of the loan, it costs them $74,461 more to borrow the same amount of money.
Think of what you could do with that kind of cash if it stayed in your pocket. For most families, $200 a month is too much to just give away.
You’ll Need a Larger Down Payment
If you have a questionable credit history, lenders might require a bigger down payment from you before they’ll give you a home loan. A good credit history makes it easier to qualify, and lenders will loan you money without you having to turn over as much of your cash.
When you buy a home, there are always fees for the transaction. Zillow says right now home buyers typically pay between two and five percent of their home’s purchase price in fees according to a recent survey. You might have an appraisal fee, a credit report fee, fees for loan origination and document processing etc. Some buyers pay those fees out of pocket, others finance them as part of their home loan. Either way, fees are separate from your down payment.
Your down payment is money you save or receive as a gift. It reduces your principal. If you have poor credit, lenders often require a big down payment because if you default on your loan and they have to foreclose, you won’t owe as much.
First time home buyers often apply for FHA loans. Currently, if you have a FICO score of 580 or higher, you qualify for a down payment as low as 3.5 percent. That means on a $200,000 home, you would need to bring $7,000 to closing in addition to the amount you owe for any closing costs.
However, if your credit score is below 580, you’ll need a 10 percent down payment for an FHA loan. That’s $20,000. You’ll have to put down $13,000 more than the borrower with a higher credit score.
You Could Get Denied Altogether
Having to pay more for a home is bad, but at least there’s a way to get your family into a home and start building long-term wealth. If you improve your credit, you may be able to refinance later at a lower interest rate, and the money you put down on your home is equity. But if your credit is bad enough, you might not be able to get a home loan at all.
It’s a painful situation we’ve seen happen time and time again. An individual or couple decides to buy a home and they figure out about how much they can afford based on monthly payments. They start looking in their price range, and eventually find a home that seems just right.
When they walk in the front door, they just know. Everything about the home feels like it was built for them. They can picture themselves living happily there for the forseeable future. In the time it takes to drive from the house to the bank, they’ve figured out where to put all their furniture and what flowers to plant in spring.
At the bank, they fill out a loan application and agree to a credit check. Then they receive the crushing news they’re unable to qualify, even with a large down payment or high interest rate. A month later they drive by their dream home and see someone else moving in.
Different lenders have different requirements. Conventional loans usually require a credit score of 620 or more. If your credit score is below 500, you might not be able to secure a mortgage at all.
Credit Impacts Earning Ability
Whether or not you can get a home loan has a lot to do with your credit. How much house you can afford connects to your income.
Bad credit can keep you from higher-paying jobs. If you make less, you can’t save for a down payment or pay off debt as quickly. You also can’t afford the higher monthly payment that comes with bigger, newer homes.
There are laws against discriminating against potential employees because of their age, race, gender and so on. However, there aren’t any laws that stop employers from using your credit to make hiring decisions. When they look at your credit, here’s the thought process:
- If you often pay your bills late, you might not be organized and responsible, important characteristics for any employee.
- If you use a large chunk of your available credit or carry high balances, you might have money trouble. When you’re in financial distress, you might be more likely to steal from your employer.
- Poor handling of your own money might indicate how you’ll manage company funds.
On the other hand, if you have good credit, you have an advantage over candidates who don’t handle their finances as carefully.
Get Help Improving Bad Credit
Credit matters when you’re buying a home. You want your score to be as high as possible for a number of reasons, but if you’re not there yet, don’t despair.
Part of what we do at WestWind Homes is work with Texans to help them repair bad credit so they can buy the home they’ve been dreaming of. We’ve helped people with poor credit move into new homes in desireable communities in as little as 90 days. Schedule your confidential consultation to find out more.