Home-loan costs typically rise as credit scores drop
- The housing crash brought tougher underwriting standards.
- Borrowers with lower credit scores can still get a loan.
- Poorer credit scores generally mean the loan will cost more.
- A borrower can raise his or her scores by reducing credit card debt.
One of the fallouts of the housing crash in the last downturn was that it made getting a home mortgage loan a much harder process.
After the bubble burst at the onset of the Great Recession and millions of people lost their homes to foreclosure, the government clamped down on the mortgage industry with more consumer protections and restrictions on loan types.
Some of the nation’s biggest banks also were hit with multi-million-dollar fines and ordered to buy back bad loans. Lenders tightened up their standards in a couple of ways so that they could minimize the risk of future borrowers defaulting. In some cases, lenders stopped offering loan products altogether. More commonly, though, they layered on additional credit requirements above the bare-bones guidelines set out by investors and government agencies that either purchase or back these loans.
In the last couple of years, however, lenders and investor groups have begun to loosen their purse strings. Analysts disagree on how easy it is get a home loan, but it is no longer roundly considered a long shot. Even borrowers with marks on their credit history can get a mortgage.
Borrowers will be evaluated carefully, however, and blemishes on their credit will affect the costs of their mortgage.
The all-important credit score
Lenders and mortgage companies consider a few factors when evaluating a borrower’s worthiness for a loan, but a person’s FICO credit score is usually at the top of the list. A FICO score can range from 300 to 850. Speaking broadly, a credit score in the mid-to-high 700s is considered good credit. A score in the high 600s to low 700s is considered fair. A score below 600 is viewed as poor.
Borrowers can take hits to their credit in several ways. Most people associate a low score with missing payments on bills, but a person’s score can also plunge by maxing out credit cards and carrying a lot of debt.
A low credit score won’t necessarily disqualify a borrower, however.
Various loan products have different standards. For example, a conventional loan purchased by one of the government-sponsored enterprises — Freddie Mac and Fannie Mae — has typically been out of reach for borrowers with a credit score below 620. A borrower can get a Federal Housing Administration (FHA) loan or a Veterans Affairs (VA) loan with a score as low as 580, however. Theoretically, the FHA program will accept borrowers with scores as low as 500.
“There is this fiction that the banks are just cherry picking the very best borrowers with high credit scores. That is simply incorrect,” California mortgage banker Joe Parsons said.
“If somebody has got a credit score of at least 620 and a down payment of at least 5 percent, and the ability to document income and assets, they can qualify for a conventional loan. If they have got 3 ½ percent down and at least a 580 credit score, then they can qualify for an FHA loan or VA loan.”
Comparing mortgage lenders will provide an idea of what loan rates are eligible for a given credit score.
The cost of poor credit
This doesn’t mean that borrowers won’t pay a price for having a low score. A borrower may not be automatically disqualified for a loan because of a poor credit score, but that loan could be much more expensive.
Fannie Mae and Freddie Mac, for example, use risk-based pricing. The formulas can be confusing, but basically it means the lower the credit score the more the borrower will pay for the loan. FHA and VA are more flexible in their guidelines, but many lenders tack on additional costs based on a borrower’s perceived risk.
Parsons said sometimes it makes sense for a borrower to pay down their credit cards first, a move that will raise their credit scores.
“By paying about $2,000 to reduce credit card balances, they will add about 15 points to their score,” Parsons said. “It takes some time to do that, but that will save them thousands of dollars.”