How Credit Score Affects Home Loan Interest Rates
The interest rate on a mortgage loan is one of the factors that determine the amount of your monthly payment. Loan payments are made up of interest and principal (the amount of money borrowed). Over time, monthly interest payments added to your principal amount can add up to a large sum of money. This is why a low-interest loan is highly attractive to a home buyer, as it results in you paying less to use the borrowed money over the life of the loan.
The interest rate that you qualify for will depend, in part, on your credit score, as this score is a means of determining the likelihood of your repayment of the loan based on your past credit actions. Another way to look at the connection between your credit score and how it affects your rate is by approaching it from a more personal perspective, such as if you have ever loaned money to a friend or family member. If that person was slow to pay back the money — or didn’t repay it at all — you are probably reluctant to lend them any funds in the future. The same is true of financial institutions. They are more willing to lend money to a person with a record of paying creditors on time. That’s why, when deciding whether or not you are a good candidate for a mortgage loan, a lender considers your credit score. Your credit score is a measure of your financial health and indicates to lenders their level of risk in lending money to you. A high credit score suggests that you are likely to repay your loan on time and may qualify you for the best — lowest — interest rate offered by that lender. Conversely, a low credit score suggests that you might submit late payments or even potentially default on the loan. In this case, a higher interest rate is offered to offset the lender’s risk.
Your credit score is most often calculated using the FICO scoring model, and is derived from information compiled by credit reporting companies. Your personal credit reports at these companies include a history of your repayment habits regarding money you have borrowed or purchases you have made using credit. Credit scores range from 300 to 900; a credit score above 700 indicates that you manage credit well and a lender is likely to be comfortable making a loan to you. A credit score lower than 700 indicates that you may have mismanaged your credit, making you more of a risk to a lender. If a lender lends money to you despite a low score, you may be required to pay a higher rate of interest on the loan.
A difference of only a few points on your credit score can add hundreds of dollars to the cost of your mortgage due to the assignment of a higher interest rate to your loan. For example, a 30-year, $220,000 loan at a 4% interest rate without any other fees would have monthly payments of approximately $1,050. However, the same loan at a 5% interest rate would have monthly payments of $1,181. The difference of $131 per month adds up to $1,572 extra paid on the loan – in interest alone – in a year’s time. Raise the interest rate to 8%, and you have a mortgage payment of $1,614 — an extra $564 per month over the 4% rate. Over the life of the loan (30 years) this is an additional $203k in additional interest that you would pay at 8% versus 4%.
Start now, before purchasing a home, to take steps to boost your credit score. Pay bills on time each month. If you do hold a balance on your credit cards, strive to maintain balances below 30% of the available credit amount. While there are other options available to lower the interest rate on a potential mortgage loan (such as having a larger down payment or paying a fee for a discounted rate) a strong credit score will go far in setting you up for a competitive mortgage loan rate.
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