REwatch: How Credit Scores Affect Mortgage Rates

2013-12-08T09:15:00Z REwatch: How Credit Scores Affect Mortgage RatesMichelle Krueger Times Columnist
December 08, 2013 9:15 am  • 

It’s a fact: mortgage interest rates are constantly changing. Across the U.S., they are currently changing at the fastest pace in over four years. That makes it challenging for home buyers on a quest for the lowest possible interest rates.

No one knows if or when mortgage interest rates will change, but the safe bet is that they will continue to rise from historic lows in the coming years.

One thing home buyers can control is their credit score. Higher numbers yield lower rates, it’s that simple.

More importantly, if your credit score falls within an undesirable range or includes unfavorable marks, some lenders may even be leery of approving a home mortgage for you. Or, if you are able to obtain a mortgage, you’ll likely pay a higher interest rate if your score falls into a lower tier. In many cases, people have had to delay their plans to purchase a new home because they were just a point or two away from the next tier with a more desirable rate.

Yes, each point is that important. The top tier ranges between 760 and 850, followed by the 700-759 tier, the 660-699 tier, the 620-659 tier, the 580-619 tier and the 500-579 tier. As you can see, with the vast majority of people falling in the 600-700 range, the difference in interest rates can vary considerably (more than 1.5 percent) whether you are in the higher or lower part of “average.” The change from the third top tier to the fourth can be as much as one percent alone.

That’s why, when you’re ready to move, you need to protect every point on your credit score – and, even if you’re not sure about moving right now, it’s always a good idea to play it safe this time of year since no one ever knows what the next year will bring.

When it comes to securing a home mortgage, several key factors are considered, and your credit score is one the most important. As a result, there are a few things you’ll want to consider carefully while shopping for holiday gifts this year.

Credit scores are based on payment history (35 percent), overall level of debt (30 percent), length of credit history (15 percent), types of credit (10 percent) and applications for new credit (10 percent).

Re-read that line carefully. While you can’t change history, you can drastically damage your credit score by increasing your overall level of debt, types of credit and applications for new credit in one quick holiday spending spree.

Level of debt is fairly self-explanatory. Your debt-to-income ratio (DTI) is one of the first things a lender will look at in order to determine if you have enough income to cover your new mortgage payment plus any existing monthly debts such as credit cards, auto loans and student loan payments. The ratio is calculated using your total monthly debt load divided by your monthly gross income.

The lower the number (below 36 is recommended), the higher the chance you will qualify for a loan.

Types of credit are another story. For example, did you know there’s a “debt totem pole?” There is and mortgage debt sits at the top (good debt) followed by auto loan debt and student loan debt, general credit card debt, and consumer loan debt and store credit card debt (bad debt).

Just imagine how all those quick-approval store credit cards wreak havoc on people’s home mortgage options, starting with the fact that research shows how opening several credit accounts in a short period of time represents a greater risk - especially for people who don't have a long credit history.

That leads us to applications for new credit, AKA inquiry traps.

A credit inquiry is a formal request to review your credit report, and really just one small element within the larger credit-scoring category of new credit.

So why is it so important?

Essentially, when you make a credit inquiry, it's a specific request to increase your level of indebtedness. As a result, credit scores drop because each new credit inquiry increases the probability that you’re taking on new, larger sums of debt, making it less likely you’ll be able to make good on your payments to creditors.

This is another area where the “debt totem pole” comes into play. Again, a credit card application is weighted heavier than one for a home mortgage, making it more damaging to your total credit score. This is because credit card debt tends to move higher over time, while mortgage debt eventually pays down to $0.

Since consumer loans and store credit cards are associated with layaway plans and "loans of last resort” with high default rates, they also have a more damaging effect on your credit score.

Give careful consideration to opening new store credit cards this holiday season if a home mortgage is in your future. While you may save an additional 20 percent or more on today’s purchase, starting those new store credit cards can cause some serious, immediate damage to your credit score. Think of it as forgoing those savings for now in lieu of paying that much or more every month for the next thirty years!

Understanding the components that make up your credit score as well as how it can affect your ability to qualify for different interest rates and loan terms is a big first step when it comes to making the move to a new home.

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