Many people dream of homeownership. But the best deals, in the form of the lowest mortgage rates, often go to the borrowers with the highest credit scores.
Credit scores are determined by agencies that compare your credit report to those of other consumers. The higher your score—generally on a scale from 300 to 850—the more likely lenders will view you as a borrower who can pay your bills on time.
Credit scores above 700 or 720 are generally the ones considered most desirable by lenders, which usually means a lower mortgage rate—or the interest charged on a mortgage.
“If you have a credit score below 680, it starts to get tougher, and your options are significantly reduced,” says Greg McBride, a senior financial analyst with Bankrate.com.
It’s hard to give a one-size-fits-all statement on what kind of mortgage rates these “subprime” borrowers might expect to see, since there are many factors involved in determining mortgage rates. But it’s generally the case that consumers with lower credit scores will borrow at a much higher mortgage rate, which will mean paying an “astronomical” amount more over the life of a loan, McBride says.
What are the options for consumers with lower credit scores?
One option is a Federal Housing Administration (FHA) loan. These loans are appealing to many first-time homebuyers who have thin credit files or can’t make a large down payment. FHA loans only require a 3.5 percent down payment, and that money can be gifted from someone else, like a parent. The FHA guarantees the loan, making it less of a risk for lenders to offer you a mortgage.
Mortgage rates will still be higher than those of non-FHA, prime borrowers, though. And if you take out an FHA loan, you’ll be required to pay private mortgage insurance premiums, which could mean forking over hundreds of dollars more per month.
Credit isn’t the only factor that comes into play when a broker is determining your mortgage rate—proof of income and down payment are also big factors. Would-be homeowners with lower credit scores can help boost their appeal to lenders by offering a larger down payment.
“It takes a lot of risk off the back of the lender. You’re less likely to default, and that might be enough to tip the scales in your favor,” McBride says.
McBride says he doesn’t recommend people whose credit scores are lower than 700 to purchase a home—at least not yet.
If you are unable to qualify for a good mortgage rate now, you may want to consider holding off on your home purchase. Raising your credit score and socking away money for a larger down payment could help you receive a better mortgage rate and a lower monthly payment down the road.
“Take your time. Put yourself in a situation to get the best rate available, which translates into more buying power,” McBride says.
To see where your credit currently stands, visit annualcreditreport.com. You can receive one free credit report from each of the three national credit reporting agencies each year, and you can obtain your credit score for a small fee.