NEW YORK (MainStreet) — While consumers who have low credit scores have fewer options to choose from, many can still qualify for a mortgage.
Lenders determine the mortgage rate based on a potential homeowner’s credit score, amount of down payment and how much debt he has compared to his current income.
What Your Credit Score Means
Credit scores play a large factor in the interest rate a borrower will receive because lenders are determining the likelihood of someone defaulting on a loan or missing payments, said Jason van den Brand, CEO of Lenda, a San Francisco-based online home mortgage service.
“It's important to remember that the costs of a loan are closely associated to how ‘risky’ it is to give the loan,” he said. “If you look like a riskier borrower, your loan will cost more.”
Low mortgage rates can play a substantial factor in a homeowner's ability to save tens of thousands of dollars in interest. Even a 1% difference in the mortgage rate can save a homeowner $40,000 over 30 years for a mortgage valued at $200,000.
Boosting Your Credit Score
A high credit score is the key to ensuring that borrowers receive a low mortgage rate. Here’s a quick rundown of what the numbers mean – a score of anything below 620 ranks as poor, 620-699 is fair, 700-749 is good and anything over 750 is excellent.
“Anything above 700 is considered to be good, but the average credit score for Americans is approximately 689,” said van den Brand. “A score of 620 to 640 will usually be good enough to qualify for any type of mortgage, but the interest rates you qualify for will probably be higher than someone who has a score of 740 or more.”
The first rule of thumb is to pay your bills on time since that makes up 35% of your score. Decrease your credit card debt, because the amount you owe makes up 30% of your score. Your credit utilization ratio should be under 30%.
The length of your credit history affects 15% of your score. This is why it's important to not completely close credit card accounts that you have had for years. Keep them open, use them sparingly and pay the balance off every month.
Any new credit, which can trigger a score-depleting hard inquiry, makes up 10% of your score, so don’t open up a bunch of credit accounts in a short period of time. The type of credit you have also affects 10% of your score. You want to show that you can manage a mix of different types of credit like installment or revolving and a variety of lines of credit such as credit cards, auto loans and mortgages.
Review your credit reports for any inaccuracies such as an incorrect outstanding balance on a credit card and correct them, said Kevin Gallegos, vice president of the Phoenix operations for Freedom Financial Network, a consumer debt resolution company.
Reasons Why Loans are Denied
In recent years, many homeowners were getting declined, because their credit score is too low. Some consumers are getting rejected, because they have experienced a bankruptcy in the last four years, a foreclosure in the last seven years, a short sale in the last four years, judgments, charge-offs and collections, said van den Brand. While a borrower could have a “good” credit score, if they have any of those issues, they might not be able to get a mortgage, he said. The best way to remedy the situation is by paying off those debts.
A consumer who only needs to pay down some debt and his bills on time could see his score improve in a couple months, while for someone who has had a bankruptcy or short sale, it could take years for his score to increase and be able to qualify for a mortgage, van den Brand said.
Opt For a FHA or ARM
Both an adjustable rate mortgage (ARM) or a Federal Housing Administration (FHA) mortgage are good options if homeowners are concerned about receiving a lower interest rate and have not been able to accumulate the standard 20% down payment.
The biggest benefit of ARMs is that they offer lower interest rates than the more common 30-year fixed rate mortgage and are good options for first-time homebuyers. Many ARMs are called a 5/1 or 7/1, which means that they are fixed at the introductory interest rate for five or seven years and then readjust every year after that, said David Reiss, a law professor at Brooklyn Law School.
FHA loans can be a good option, because they require a much smaller down payment of 3.5%. They also do not require high FICO scores, but buyers must pay private mortgage insurance (PMI) each month, which costs another 0.5% to 1.0%. Given that young households tend not to have the savings for a substantial down payment, FHA loans can be particularly attractive, Reiss said.
If your score is between 580 to 600, you could qualify for a mortgage under FHA guidelines, said van den Brand. Any borrower who closed an FHA loan after June 3, 2013 is required to make mortgage insurance payments for the life of the loan no matter how much equity they build. Homeowners who build at least in 20% equity could refinance to a conventional loan to get rid of the PMI.
Other Mortgage Options
Borrowers should also look into home affordability programs offered by state and local housing agencies and financial institutions who could provide loan options with both low interest rates and down payments. One option for borrowers is TD Bank’s Right Step program, which provides home buyers with an alternative to FHA- backed loan products and features a 3% down payment option, said Malcolm Hollensteiner, director of retail lending sales for TD Bank in Cherry Hill, N.J. Borrowers will also see “significant” savings on their monthly mortgage payment thanks to the loan's elimination of PMI.
Another option is to get your mortgage from your local community bank or credit union because they might be “more lenient with their guidelines and will accept a lower credit score,” said Mike Mahoney, the chief underwriter at Genworth Mortgage in Raleigh, N.C.
“If you are buying in that community, sometimes they do business quite differently, because they know their customers and the real estate well,” he said.
Putting Your House Purchase On Hold
For some consumers, it makes sense to wait another year or two so they can improve their credit score or save more money for a larger down payment to get the lower rate.
“Just because an option is available, it does not mean it makes sense to buy a home if your credit score is that low,” said Whitney Fite, president of Angel Oak Home Loans in Atlanta. "Sometimes it’s better to wait until you are in better financial health before committing to a mortgage.”
--Written by Ellen Chang for MainStreet