Lower Mortgage Rates Means Average Borrowers Might Need Higher Credit Scores

Lower mortgage rates could put a damper on home buyers seeking typical 30-year mortgages as lenders could become stricter and require higher credit scores.

Potential homebuyers who are set to start shopping during the peak home buying months should be prepared to have higher credit scores to qualify for the lowest mortgage rates available since the amount of credit made available by banks declines slightly as the rates move lower.

The average 30-year fixed-rate mortgage was 3.58% on Monday and remains the same as last week, according to Bankrate, a North Palm Beach, Fla.-based financial content company. This rate means owners will pay $454 per month in principal and interest for every $100,000 that is borrowed.

"Borrowers with credit scores above 740 are positioned to get the best rates in any environment," said Greg McBride, chief financial analyst for Bankrate. "The ability to get approved is really only in question for borrowers that were marginal at the outset."

While the historically low mortgage rates means consumers can take advantage of lower monthly payments and have an additional 6% in buying power, lenders are tightening their requirements for credit scores since the amount of money they are making is declining, said Jonathan Smoke, chief economist for Realtor.com, a Santa Clara, Calif.-based real estate company. The average 30-year rate nationally was 3.6% on May 10, the lowest rate in three years.

"Lenders are being a bit more risk averse than last year when average conforming mortgage rates were closer to 4%," he said. "This makes rational sense, because their margins are very thin."

Higher FICO scores are being required in conforming loans, which include typical 30-year mortgages and FHA and VA loans, compared to the end of 2015 when mortgage rates were 0.50% higher, said Smoke. A jumbo loan is typically one that is over $417,000 in most markets, but  that depends heavily on the location of the home and is at least $625,000 in designated high cost markets.

The average FICO scores for conforming loans were 749 compared to FHA loans of 675 in April while jumbo loan borrowers have a score of 764, he said.

"Lenders are certainly not taking on more risk," said Smoke. "We have witnessed data around credit availability conditions tightening a bit as it was 7% easier to get a mortgage at the end of 2015 compared to 2014. So far this year, credit conditions have tightened by 2% compared to December."

Mortgage rates in the next three to six months should remain fairly steady. The volatility from one week to another week remains higher with a 0.07% average movement and has emerged as a trend for 2016, said Smoke.

"I do not predict there will be a substantially better or worse economy throughout the spring and summer months," he said. "It is unlikely at this point. If mortgage rates jump in either direction based on the jobs report or other major economic data, it will not be a permanent move."

The amount of credit available to consumers for a mortgage will increase when average 30-year mortgage rates rise above 4% and are trending toward 5% for traditional 30-year ones, because lenders will be able to make more money without taking on "undue risk," Smoke said.

Lenders typically are more selective in low interest rate environments, especially if the buyer's credit score is on the fence, said Ralph McLaughlin, chief economist at Trulia, a San Francisco-based real estate website. The mortgage rate does not have "much of an effect on purchasing behavior in practice," he said.

Even if rates were to rise by 1%, which is highly unlikely, buyers who stay in their homes for five years or more are still coming out ahead compared to renters, McLaughlin said.

"Wait to have the right down payment of 10% to 20% because interest rates would have to be 6% to 8% where it might impact the bottom line and renting would be a better option," he said.

How to Improve Credit Scores

Potential homebuyers should take a look at their credit score 12 months before they plan to shop around for a mortgage and should aim for the upper 700s and above for the lowest rate, said Bruce McClary, spokesman for the National Foundation for Credit Counseling, a Washington, D.C.-based non-profit organization.

"If your credit score is in the 700s, you will get a decent shot," he said. "You don't want to be in the mid to low 600s, because you won't get the most competitive interest rate."

Credit scores can improve easily when errors on the report are fixed, but companies have 30 days to respond to a dispute made by consumers. Correcting an error can easily improve a consumer's credit score.

"Homeowners need to be focused on fine tuning their scores," said McClary. "There is not as much collateral damage when you find the error sooner. It's a quick fix in the grand scheme of things."

Missing payments can lower a credit score by 100 to 200 points, although once a consumer makes on time payments, it will rebound.

"It takes up to 12 months or longer to get back where you need to be, because the drop takes place almost instantaneously, while the climb out takes a longer time," he said. "One misstep can set you back quite a ways and takes a long time to get you out of your point deficit and you can't really compensate for it."

Consumers should not apply for new credit cards or make major purchases which require financing before they get approved for a mortgage, because those activities will also lower your credit score, McClary said.

"Don't close down a credit card you've had for ten years, because once you let the genie out of the bottle, you can't put it back in," he said. "Instead of buying the house when you wanted, you might be looking at longer period like waiting 12 months instead of six."

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