Why Your Credit Score Matters When Purchasing a Home

• Your credit score and credit report are key ingredients in your mortgage application. 
• Your FICO score is based on the data in your credit report. As such, it is vital that you evaluate it for errors or missing information BEFORE approaching mortgage lenders. 
• A high FICO score tells lenders that you may be a low-risk borrower.

As the last traces of cold weather fade and with it, the end of the school year, the real estate market is swinging into high gear with peak season. Top on the list of questions for prospective homeowners is how much home they can afford and how low the limbo stick can go concerning mortgage rates. The answers to both of these questions rest heavily on the borrower's credit score and, specifically, their FICO score.

Why Your FICO Score Matters

Credit scores are like report cards for your financial health. From the lender's perspective, the FICO score predicts how likely borrowers can re-pay loans and what interest rate should apply given this level of risk. FICO scores are used for mortgage loans, credit cards to car loans.

Equifax, Experian, and TransUnion are the three major credit agencies that collect credit information and calculate FICO scores. Since there is no single formula for calculating these scores, each bureau's FICO score may vary. The score, however, is unlikely to differ by very much—perhaps by five to ten points, or approximately one percent to two percent on the FICO scale of 300 to 850.

The components that are used to calculate a person's FICO score break down into five categories, shown below, from biggest impact to smallest impact:

Payment History (35%)

Payment history measures a person's payment track record. The payment history portion of the FICO score highlights several factors, including:

• Whether any late payments have occurred
• The frequency of late payments
• The size of the late payments relative to the total outstanding balance of the debt
• Whether the borrower, despite the late payments, has a history of ultimately satisfying their debt or letting the debt lapse into collections

Given the central importance of payment history in calculating a FICO score, making payments on time and in full are key to enhancing your score and will serve as an important benchmark in determining your mortgage rate.

Amount Owed on Each Credit Line (30%)

Second, on the list of ingredients used to calculate FICO scores is the total amount of money that a person owes. Credit lines that have been drawn to capacity will be viewed less favorably than those with a little breathing room. Likewise, timely and full payments are viewed favorably and are key to enhancing your credit score.

Length of Credit History (15%)

Longevity is vital to credit reporting agencies when calculating your FICO score. A longer credit history positively impacts your credit score, and a shorter credit history usually affects a credit score adversely. One step that can help strengthen credit history is keeping old credit cards that are no longer used active and open rather than closing them. 

Credit Mix (10%)

The mix of credit you have represents the various types of accounts you have open. Lines of credit such as a credit card represent one type of credit, while installment credit accounts like student loans and car notes represent another type. To increase the diversity of credit in your portfolio, you might consider opening a small personal loan instead of adding a third or fourth credit card. Different credit types can demonstrate your experience in repaying various forms of debt.

New Credit (10%)

In addition to looking at your credit mix, credit bureaus often look at how long ago you established new credit accounts. While there’s nothing wrong with opening a new account, several accounts opened recently and in quick succession may cause a rise in eyebrows among lenders. 

Suppose you are considering applying for a mortgage. In that case, you can enhance this portion of your score by holding off on opening any new credit card accounts during the period that you will be applying for a mortgage.

FICO Credit Score Range

As mentioned above, five major factors impact your FICO score:

1) Your payment consistency

2) The amount you owe relative to your total available credit

3) How long you’ve had credit

4) The various types of credit you have

5) How much credit have you added on recently.

Five is a favorite number among credit bureaus as there are likewise five categories they’ve defined to rate your credit score.

300-580: Poor  A FICO score that is under 580 is categorized by the credit reporting agencies as Poor. Buyers who are beginning their home search and have FICO scores in this range should be prepared to make a higher down payment on their home. A ten percent down payment is required for FHA-backed loans when FICO scores are between 500 and 579. FHA-backed financing is not available for FICO scores below this, and generally, mortgage financing from non-FHA-backed lenders will be very difficult to find. 

580 to 669: Fair  FICO scores ranging from 580 to 669 are classified by the credit bureaus as Fair. Scores in this range qualify for a home mortgage, though the choice of lenders will be limited. Fortunately, with a score of 580 or higher, the down payment required from FHA is only 3.5 percent versus the ten percent required for 500 to 579.

670 to 739: Good FICO scores that fall within the Good range are at or are higher than the national average FICO score, which currently ranges from a low of 700 to a high of 710, depending on the credit bureau. Mortgage loans for these FICO scores tend to be widely available, and mortgage interest rates are competitive. As of late April 2022, the mortgage rate for a fixed-rate 30-year mortgage loan for a credit score classified as Good was approximately 5.3 percent.

740 to 799: Very Good A FICO score of Very Good is an indicator to lenders that consumers pose a lower credit risk and thus may be more likely to repay their mortgage. 

800 to 850: Excellent FICO scores in the Excellent or Exceptional range are considered the most desirable by lenders. Such borrowers will have access to mortgage rates, fees, and terms that are extremely competitive.

The Money Wrap-Up

Your credit score and its underlying determinants are key ingredients in your mortgage application. Because your FICO score is based on the data in your credit report, you must evaluate your credit report for errors or missing information. The three major credit reporting bureaus that calculate FICO scores use slightly different methods, so your bank or mortgage broker will likely request your score from all three agencies and use an average of the three. 

In addition to your credit report and FICO score, your mortgage lender will assess your employment income (and any other income), your debt amount, and total assets to determine your mortgage amount and interest rate.