One of the keys to unlocking your dream home is understanding the state of your financial health, not wealth.
If you will be using a lender to finance your home, you will need to know what is a good credit score to buy a house. While income, savings and downpayment are important, it’s your credit score that will qualify you for a loan and help determine the kind of interest rate you will pay.
Before we dive too deep into what is a good credit score to qualify for a home loan, let’s start with the basics to help keep your head from spinning.
What is a mortgage?
This doesn’t have to be complicated. A mortgage is a loan issued by a bank or other lender for the purchase of real estate. Mortgage loans vary by size, maturity, interest rate and method of payoff, making owning a home more attainable for people who don’t have a money bin like Scrooge McDuck.
Your mortgage loan will likely be the largest loan you take out, with an overall price tag that might seem overwhelming. But the number that most of us can relate to best is the monthly payment.
Your monthly mortgage payment is made up of four parts:
Principal is the total amount of money loaned to you by the lender – usually the purchase price of the home minus the amount of your down payment and closing costs. Principal will gradually decrease as you pay down the loan balance.
Interest is the amount the lender charges you to use their money. Your interest rate and term of the loan will affect your monthly interest payment.
At the beginning of your loan term, most of your monthly payment will go towards interest. If you have an adjustable rate mortgage (ARM), you will initially pay a low interest rate (which makes your monthly payment lower) but it will increase over time.
Interest rate is important: Even a two percent difference on your interest rate can mean several hundreds of dollars a month more for your payment.
Property taxes on your home are assessed by your city or county and based on the worth (not sale price) of your home. Usually, property taxes are estimated for the year and an amount is added to your monthly payment that is placed in escrow to pay your taxes (usually annually). If the actual tax assessment is more or less than the estimate, your future mortgage payment will be adjusted.
Your monthly payment will include one or two types of insurance: Homeowner’s insurance and private mortgage insurance (PMI).
- Homeowner’s insurance protects your home in the event of damage from a hazard such as fire or tornado, as well as protection for you if someone has an accident in your home. Homeowner’s insurance must be in place prior to closing and premiums may change annually, affecting your monthly payment. Homeowners insurance is required to be paid as part of your mortgage payment.
- Private mortgage insurance is often required by lenders if you make a down payment of less than 20 percent. It protects the lender if you were to default on your loan and is a small percentage of the original loan amount. PMI is usually not required once you reach 20 percent of equity in your home.
There are other things to consider when looking at your monthly housing expenses, such as HOA dues and maintenance expenses.
What is credit score determined by?
One of the first things that happens when you apply for a mortgage is a review of your credit report. The report used for mortgage loans is a combined report with information from three credit bureaus: Equifax, Experian and TransUnion, and helps to give lenders a clear picture of how responsible you are with handling borrowed money.
Information from these credit reports is taken and assigned number values. These values are then plugged into a formula. The most popular credit score model used is the FICO score, although there are other scoring models that might be used for different purposes.
For the most part, your credit score is comprised of five main factors:
35 percent of your credit score is based on how you handle your payments. If you pay on time, your behavior positively impacts your score, but if you are late, the information is recorded in your credit report, and then used in the calculation of your credit score. Other non-credit payments, such as rent and utilities can show up negatively in your report.
Amount of credit used:
Another 30 percent of your credit score has to do with how much of your available credit is being used. If you are close to the maximum on your credit cards, it will drag down your score.
Age of credit:
The age of your credit accounts for 15 percent of your credit score. There are two parts to the length of your credit history:
- Your oldest account is considered, including how long it has been open. This provides an idea of how long you have been using credit. The longer you have used credit, the better it is for your credit score.
- The other part is the average age of all of your accounts. The higher the age, the better your credit score, and the longer you have accounts in good standing, the more it will help your credit.
Types of accounts:
The credit scoring formula takes into account the diversity of your accounts, and accounts for 10 percent of your FICO score. Having revolving accounts, like credit cards and car loans, can show that you handle different types of credit responsibly. But pump the brakes before you take out a payday loan or department store card, as these types of credit are less favorable.
New credit and inquiries:
The final 10 percent of your credit score is based on the credit inquiries made on your behalf. When you look at your own credit, or if someone looks at your credit without you asking them to, it doesn’t factor into your credit score. However, if you apply for new credit, it will be included in calculations for your credit score. Your score can be lowered if you apply for too many credit accounts at once.
The minimum FICO score needed to buy a house is never set in stone.
All things considered, your FICO score will be a number between 300 and 850, with most scores ranging from 650-800 – the higher the better.
If you don’t know your credit score or you’ve never looked at your credit report before, it’s a good idea to so by pulling your free credit report.
How to raise credit score for mortgage
Does it look like your credit score took a dive in the deep end? Don’t fret!
If you credit report shows a low number, set up a call to speak with your lender about your score to see what loan options you may qualify for. You just may be surprised.
If your lender advises you to work on raising your credit score, put your head down and get to work by implementing some of these credit-boosting strategies:
- Pay your bills on time each month.
- Pay at least the minimum payment – more if you can on debts where you carry a balance.
- Don’t add to the balance on credit cards when you’re trying to pay them off. Keep one low-interest card for travel and emergencies if needed.
- Move your accounts to banks or credit unions with no or low fees.
- Consolidate student loans.
- Refinance a high-interest car loan.
- Transfer credit card balances to lower interest rate credit cards when possible. But don’t close accounts that are paid off. The length of time you have credit open has a positive impact on your credit scores.
- If you fall behind on payments, attempt to pay past due bills as quickly as possible, but keep your other accounts in good standing.
- Create a small emergency fund to fall back on.
How to boost credit score without credit
Buy a house, they said. It will be a great investment, they said. But how can you qualify for a mortgage loan based on credit score if you don’t have any credit?
The easiest way to establish credit is by opening a credit card. Cardholder be warned. As easy as it is to build good credit, it’s equally as easy to fall into spending habits that result in bad credit.
When you open a credit card account, follow these rules to help you establish good credit while avoiding the pitfalls of debt:
Keep to a budget:
Before you make a purchase with your credit card, make sure you have money in your checking account to cover the cost, and make sure that the purchase fits within your budget.
Track your spending:
After you buy something, record the transaction in a ledger, or in personal finance software. When you track your spending, you can reduce the chances that your credit card purchases will get out of control.
Only buy one or two small items each month:
As part of your budget, choose one or two items to buy with your credit card each month, such as gas or groceries. Make sure these are small enough purchases that they fit into your budget.
Pay off most of your balance each month:
If you stick with your budget, there should be plenty of money in your checking account to pay off most of your credit card balance monthly. You should leave a small balance at least once each 6 month period so that the credit formula reads the activity on your account. This way, you will be able to build good credit, without paying lots of interest on your credit cards.
As you work to establish good credit, you should follow the basic rules of good personal finances. This means that you need to avoid spending more money than you earn, as well as setting money aside in savings to serve as a safety net in times of financial difficulty.
If you establish good financial habits, you will not need to turn to credit cards and loans to help you get out of tight spaces. That way, you can maintain your good credit over your lifetime.