Credit and Your Mortgage

Of all of the factors that go into determining the rate you will be asked to pay for your mortgage, perhaps none is more far-reaching than your credit rate. Like other types of loans, mortgage loans are based on risk. And one of the primary instruments a mortgage lender uses to assess risk is the personal credit score.

While credit can have an impact on everything from loan rates and terms to car insurance fees to whether or not an employer choose you for a job, sadly many individuals remain largely in the dark when it comes to their scores and how to improve them. These guidelines will help consumers understand the importance of their credit score and credit history in qualifying for the best interest rates and loan terms when applying for a first or second mortgage or home equity loan.

First, some background. Your credit profile is comprised of two primary components: your credit report and your credit score. Your credit report is a listing of all of the active accounts you currently have with lenders, including personal loans, auto loans, home loans and other loans, as well as store and credit card accounts. In addition, your credit report also contains information about inactive accounts that have been active within the last seven years. Even an account that you closed six years ago can still be reflected on your current credit report.

In addition to listing the accounts and the specific lenders associated with those accounts, your credit report lists your current balance, your monthly payment, and your payment history, including any late payments. If an account has been closed, your report will indicate whether or not it was closed by the consumer or the lender. Credit reports also list chargeoffs, which occur when a lender essentially writes off a loan amount as a bad risk, and which typically occurs with smaller balances that are left unpaid over a prolonged period of time.

Your credit report also contains information about any court judgments that may have been made against you as the result of a loan default. And it contains an entry for any credit card or other loan you may have applied for, whether you were approved or not.

In essence, your credit report is a detailed listing of every credit activity you have encountered or initiated within the past seven years.

Your credit score is a numerical value that is assigned to you based on the information on your credit report. Those with good credit histories reflected in their credit report will have higher scores than individuals with late payments or chargeoffs. Even a single late payment can have a significant impact on your credit score. Your credit score may also be referred to as your FICO score, for the Fair Isaac Corporation, the entity that determines credit scores that are used by lenders.

Most individuals who have a basic understanding of credit scores understand that their credit score will decline if they are late with a payment or if they have a judgment or default on an account. But even applying for too many cards can make you appear like more of a financial risk, causing your score to decrease. For this reason, opening a credit card just for the frequent flier miles or other perks, even if you never use the account, can have a negative impact on your rating. Closing accounts can also cause your rate to go down in many cases.

Credit scores also take into account the length of your credit history. For instance, your rate will be more likely to go up or remain stable if you have a long credit history, with credit accounts that are in good standing and that are several years old. A credit account in good standing that is only a year old will not have nearly as much impact on your score. However, an account that is not in good standing, regardless of how old it is, usually will have an equally bad effect on your score.

Mortgage lenders use the credit score, as well as the credit report, to determine your risk – that is, how likely you are to make late payments or even default on a mortgage loan. Even a long job history can be overshadowed by a poor credit rating or report, resulting in much higher interest rates on mortgages and other loans, or even causing you to be turned down for loans.

For these reasons, keeping an eye on your credit report is essential. Before applying for a mortgage, it is a good idea to get a copy of your credit report – you are entitled to a free copy of your report each year, from each of the three major credit bureaus – and check it for errors. If you find an error, there are simple dispute processes you can use to see that those errors are fixed.

Credit Scores and Mortages Rates

4 steps to a good mortgage rate

1. Factors beyond credit scores.
2. Scrutinize your credit reports.
3. Bump up your credit score.
4. Don’t close any accounts.

Each of the three major credit bureaus, Equifax, Experian and TransUnion, collects data from your lenders about your history of borrowing and paying back credit. They compile that information into your credit report, which any lender can access whenever you apply for a loan. The Fair Isaac Corp. is the major producer of credit scores. They take the information from those credit reports, apply their own trade-secret formula and, based on the three credit reports, distill three credit scores for you into one score ranging from 300 to 850.

A new credit scoring system has been developed by the three major credit bureaus — the VantageScore. Their VantageScore reports are available for $5.95 each, a fraction of the cost of the FICO score. However, the scores are not a direct substitute for each other and mortgage lenders continue to look at FICO scores when reviewing mortgage applications, so they are the scores a mortgage borrower should buy.

Borrowers with high FICO scores — the top tier ranges between 760 and 850 — can expect lenders to offer them lower interest rates and more loan choices. Scores of 620 or lower usually place a borrower in the “subprime” category, and they can expect to be quoted significantly higher interest rates and may be offered fewer varieties of loans. A FICO score of about 500-520 is generally the minimum that will qualify for a mortgage.

Fair Isaac’s consumer Web site offers a chart that is updated regularly and shows how your FICO score can affect your interest rate.

For example, here’s what a borrower could have expected to be charged in interest for a $300,000 30-year fixed rate mortgage, based on his credit score, according to March 2007 interest rates:

How FICO score affects mortgage rates

760 to 850 tier 5.780% 620-659 tier 7.096%
700-759 tier 6.002% 580-619 tier 8.583%
660-699 tier 6.286% 500-579 tier 9.494%

Such variations in interest rate can add hundreds of dollars to your monthly payment and can make a big difference in the amount of debt for which you can be qualified.
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Factors beyond credit scores

While scores are important, they are not the only thing lenders take into consideration when approving a mortgage. And low scores aren’t insurmountable obstacles, says David Reed, an Austin, Texas-based mortgage broker and author of “Mortgage Confidential: What You Need to Know That Your Lender Won’t Tell You.”

“The FICO is one of the factors, not the only one.”