How credit scores affect your ability to buy a house

Only a tiny portion of homebuyers are able to pay for their houses outright, leaving the vast majority to rely on a home loan to finance their purchase.

Your ability to secure a mortgage, however, is closely tied to your FICO score, a three-digit number that banks and other lenders use to assess your credit risk. The higher your rating, the higher your chances of being approved for a loan — and the better the interest rate you’ll get.

What home loans can you get with your current credit score? How can you raise it to get the best mortgage rates? We answer these questions and more in this in-depth piece.

CONTENT AT A GLANCE

What mortgage type should you get and what credit score should you have?

• Conventional mortgage
• FHA loan
• VA home loan
• USDA loan
• Jumbo loan

What if you’re buying a second home?

What are the factors that affect your credit score?

• Payment history
• Credit utilization
• Length of credit history
• New credit
• Credit type

How can you improve your credit score?

• Quick fixes
• Check your credit report for errors
• Become an authorized user
• Long-term fixes
• Pay bills on time
• Whittle down debt
• Don’t open new lines of credit

What else do mortgage lenders consider?

• Income
• Employment history
• Debt-to-income ratio
• Down payment
• Savings

Can you still buy a home if you have bad credit?

• Apply for federal loan programs
• Get a co-signer
• Make a bigger down payment

Conclusion

What mortgage type should you get and what credit score should you have?

The good news is that you have several home loan types to choose from, though each has its own qualifications and minimum credit score requirement.

IDEAL CREDIT SCORES FOR VARIOUS HOME LOAN TYPES

Conventional mortgage
Ideal credit score for buying a house:620

A conventional mortgage is a home loan that is not secured by the federal government. They are offered through banks, mortgage lenders, and credit unions, and impose stricter lending standards since they aren’t government-backed. Nevertheless, most conventional mortgages are small enough to be “conforming,” meaning government-sponsored enterprises like Freddie Mac or Fannie Mae can buy them from lenders and effectively guarantee them.

You’ll have to go through the standard mortgage application process and supply proof of creditworthiness, including your credit history, pay stubs, and asset statements. Conventional mortgages also require a higher credit score (620+) and down payment (ideally 20%), so your finances must be in tip-top shape when applying.

On the upside, such mortgages are often fixed-rate, meaning the interest rate is set and not affected by changes in the real estate market. Conventional home loans also tend to be approved much faster than government-insured ones and you can borrow larger amounts.

Federal Housing Authority (FHA) loan
Ideal credit score for buying a house: 580

Housing is one of life’s biggest expenses. Luckily, FHA loans make it easy for middle-income earners to make their dream of homeownership come true. Such mortgages require markedly lower credit scores and down payments, and are viable even for buyers with higher debt-to-income ratios. This is possible because the federal government insures your loan, meaning it will cover the balance if you default on your mortgage. FHA loans are available through approved lenders, which include banks and credit unions.

Of course, this option has caveats, too. To begin with, the FHA caps the amount you can borrow to $548,250 for 2021, so your real estate options may be limited. And while the down payment required can be as low as 3.5%, that number shoots up to 10% if your credit score is lower than 580. Since you will be making less than the standard 20% down payment, you will also be required to get private mortgage insurance, which is about 1.75% of your total loan amount.

VA home loan
Ideal credit score for buying a house: 620-640

To support service members and their families, the Veterans Affairs (VA) office provides very attractive mortgage terms. These terms often include zero (or very low) down payment, waived private mortgage insurance, lower closing costs, no prepayment penalties, and competitive interest rates. Even better, VA loans are available not just to active service members and veterans but to their surviving spouses as well. In many cases, you can borrow 100% of a property’s value outright, making the homebuying process more streamlined.

Like FHA loans, VA loans are secured by the government and are available through accredited lending institutions. The VA itself does not have a prescribed minimum credit score — it only requires borrowers to be a “satisfactory credit risk.” That said, many lenders interpret this guideline to mean a credit rating of 620 or higher. Naturally, the higher your score, the higher your likelihood of being approved and not paying a down payment.

USDA loan
Ideal credit score for buying a house: 640

The U.S. Department of Agriculture also offers mortgages to people who couldn’t otherwise secure a conventional loan. It comes with excellent benefits, too, including zero down payment, lenient lending criteria, low interest rates, and long repayment periods (up to 38 years).

However, this loan type does come with quite a few requirements. The most crucial of these is location, as the home you buy must be located in an area with a maximum population of 35,000. There are also income threshold limits, so this option is suited for low-to-mid-income borrowers. Likewise, your home must be your primary residence and cannot be turned into a rental property. Lastly, you are required to pay a loan guarantee fee equal to 1% of your mortgage, along with an annual fee of 0.35%.

There are actually two USDA loans to choose from:

• Guaranteed USDA loan — The loan is acquired through accredited lenders and the USDA guarantees up to 90% of the borrowed amount. There is no credit score requirement per se, though having a rating of at least 640 will boost your chances of getting approved. Lenders set their own interest rates, so be sure to shop around to get the best deal.
• Direct USDA loan — As the name suggests, the mortgage is issued directly by the USDA. Hence, you can borrow 100% of the funds you need to buy a house. Again, a credit score of at least 640 is ideal but you may still qualify if you have a lower rating provided you have no record of financial delinquency. The interest rate is around 2.5% a year, though certain subsidies can lower this to just 1%.

Jumbo loan
Ideal credit score for buying a house: 700+

So far, all the mortgage options we’ve discussed are for people looking to buy a typical home. But what if you want to own a luxury property that’s worth considerably more than the median housing price?

In cases where the amount you want to borrow exceeds the FHA mortgage limit and does not conform to Freddie Mac or Fannie Mae guidelines, you can take out a jumbo loan instead.

Given the size of your loan and the lack of a guarantor, the lending requirements will be significantly stricter. To get the best interest rates possible, a credit score of 700 and above is imperative. Similarly, you must have a very low debt-to-income ratio, which tells lenders that you are not overburdened by other loans. While other mortgage options let you make a very small down payment, many jumbo lenders will require a down payment of up to 30%. It also helps to have 6-12 months’ worth of mortgage payments in savings as further proof of your financial capability.

That said, interest rates for jumbo loans are comparable to those of conventional ones. And since you can take out a much larger loan, you can buy properties in more desirable and competitive locations.

What if you’re buying a second home?

Buying a second home can be a great investment, especially if you’re planning on renting it out when you’re not using it. That said, there are important financial considerations you should mull over before applying for a second mortgage.

Fannie Mae sets a minimum credit score of 640 for second homes provided you can make a 25% down payment. As with the above-mentioned mortgage types, however, the higher your credit score, the better your chances of getting approved and the more favorable the interest rates you’ll get.

Mortgage lenders will also look for a debt-to-income ratio no greater than 45%. This ensures that you are able to pay your two mortgages simultaneously.

Most second home buyers will use equity-based financing, namely:

• Home equity loan — If you’ve been diligently paying off your first home, you can borrow against its equity to finance your second property. The greater the equity you have, the bigger the amount you can borrow. In this arrangement, a mortgage lender will give you a lump-sum payment on condition that your home’s equity will serve as collateral. The lender will then put a lien on your current house as surety in case you default on your loan.
• Home equity line of credit (HELOC) — Unlike a home equity loan, a HELOC is simply a revolving fund. Your lender will issue a special check or credit card that you can charge expenses to within an approved “draw period.” You can use this line of credit to pay for your home and you must make minimum monthly payments as you would with a standard credit card or personal loan. At the end of your draw period, however, you must repay the loan either in full or over a specified period of time.

What are the factors that affect your credit score?

Knowing what credit score you need to get a mortgage is one thing, but meeting that number is quite another. If your rating isn’t as high as it needs to be, it helps to understand the factors that credit bureaus use to determine your score. These five components comprise your rating and each one has a specific weight:

• Payment history (35%)

Do you pay bills late or on time? If you’re the latter, your chances of getting a good credit score are higher. Payment history is the single biggest factor that affects your rating because it tells credit bureaus that you can be trusted to pay what you owe. Responsible payment behavior covers everything from paying your phone bills to your mortgage on time. Of course, the more unsettled payments you have — and the longer the delinquency — the bigger the downgrade to your credit score. Late payments can stay on your credit report for as long as seven years, so avoid any and all delinquencies.

• Credit utilization (30%)

Another important factor is your credit utilization, which measures how much money you owe vis-a-vis your credit limit. Credit bureaus (and by extension, lenders) perceive owing a lot of money as a sign of financial distress and may indicate that you’ll struggle to pay back your home loan. Most financial experts recommend keeping your credit utilization below 30% — low enough not to raise red flags, but high enough to help you establish a solid credit history. This includes all credit available to you, from your personal credit cards to your business’s line of credit. Should your utilization be higher than ideal, aggressively pay off outstanding loans to lower the ratio.

• Length of credit history (15%)

Another key determinant is how long your credit history is. The more extensive it is, the more trustworthy you are because you have a track record of borrowing money and paying it back in full. Unfortunately, there’s no shortcut to building credit history; you’ll just have to build it the old-fashioned way through time and patience. However, you can avoid shortening your credit history by not closing your oldest credit card and not opening new lines of credit before buying a house. Not sure how long your credit history is? Just add the age of your credit cards and divide them by the total number of cards you have. If you’ve owned your cards for eight and six years respectively, your credit history averages out to seven years because [8+6] / 2 = 7.

• New credit (10%)

Getting new credit cards can be a double-edged sword. Doing so can increase your borrowing limit and thereby lower your credit utilization. It could also enrich your credit history and make you more credible as a borrower. As discussed above, however, each new card you open effectively shortens your credit history’s length. Moreover, it also forces the issuer to do a “hard” inquiry on your credit report, which may lower your score by up to 10%. Each hard inquiry can stay on your report for up to 24 months, which is why home buyers are discouraged from opening new credit accounts prior to getting a mortgage.

• Credit type (10%)

What kind of credit you have can also raise or lower your score. By and large, credit bureaus want to see a mix of accounts: credit cards, business loans, car loans, etc. The fact that multiple lenders have granted you credit bodes well for your score. Likewise, being able to manage various credit types means you are likely to pay off your mortgage. Having more than one credit type is vital if your borrowing history is sparse or not well-established.

How can you improve your credit score?

Now that you have a firmer grasp on how your credit score is computed, what can you do to raise it? Below are effective strategies you can try:

Quick fixes:

• Check your credit report for errors — Credit bureaus are not infallible so carefully review your reports for any discrepancies. Keep an eye out for wrong transactions reflected in your account (especially if you have a common name), possible identity theft, closed accounts reported as open, late crediting of payments, and balance errors.
• Become an authorized user — Can’t get approved for a credit card? Ask to be added as an authorized user on someone else’s. This tactic is suitable if you have a trusted loved one who’s willing to let you piggyback on their excellent credit history. Needless to say, you must pay back whatever you charge on the card ASAP or you may end up lowering the credit score of the principal cardholder.

Long-term fixes:

• Pay bills on time — Always settle your outstanding bills before their due date to avoid being reported as a delinquent payer to the credit bureaus. Luckily, many banks have an auto-pay facility that makes this task a breeze.
• Whittle down debt — The sooner you pay off your debt, the more credit you free up, and the lower your credit utilization will be. When choosing which credit account to pay off first, you can choose either the loan with the highest interest rate or the one with the lowest balance.
• Don’t open new credit lines — As mentioned above, do not open new credit lines to prevent a hard inquiry into your credit report. If you’re the type of person who opens and closes credit cards just to take advantage of freebies, you may want to hold off on this activity for the time being.

What else do mortgage lenders consider?

Whether you get approved or not for a loan is ultimately the lender’s decision. When evaluating your application, they will often take into consideration these factors:

• Income — Lenders will only grant a home loan if they’re confident you can pay them back. The biggest indication that you can is your paycheck, as people with a steady and healthy income are seen as highly creditworthy. Lenders base the amount you can borrow on your annual salary and your mortgage will likely be 2 to 2.5 times your gross annual income.
• Employment history — Just like employers, lenders tend to be wary of job hoppers. They prefer mortgage applicants who are established in their roles and have been with their company for several years as this is a sign of financial stability. If you’re thinking of buying a house soon, put off getting a new job until after you’ve closed on the property.
• Debt-to-income ratio — It doesn’t matter how much you earn if most of it goes to paying off debt. That’s why lenders also carefully scrutinize your debt-to-income ratio. The closer you are to maxing out your credit limit, the higher the chances you’ll struggle to pay back your home loan. As mentioned above, keep your credit utilization below 30% to boost your chances of getting approved for a mortgage.
• Down payment — Only in rare instances will a bank finance 100% of a home’s asking price. Most likely, you’ll make a 5% to 20% down payment on the property as proof of your financial capacity. The bigger your down payment, the less risky you will be in the eyes of lenders.
• Savings — Aside from a hefty down payment, you should also have a considerable amount of cash in savings. This provides lenders with added surety that you can continue paying your mortgage even if you encounter economic headwinds like job loss. Financial planning experts suggest having anywhere from 6 to 12 months’ worth of your salary in an emergency fund to cover all your bases.

Can you still buy a home if you have bad credit?

Yes, you can still own a house even if you don’t have a stellar credit score, though getting a mortgage will be more challenging. Here are some things you can do to secure financing for your purchase:

• Apply for federal loan programs — Several of the loan types discussed above are designed specifically for people with less-than-ideal credit scores. Moreover, many of them require a much lower down payment, which further lowers the hurdle to homeownership.
• Get a co-signer — If your credit score doesn’t qualify you for a mortgage, consider having a friend or family member co-sign your loan. Do note that they will be responsible for paying your mortgage if you default on it and any missed payments will dent their credit score, so this option is not to be taken lightly.
• Make a bigger down payment — Sometimes, a bad credit score is the product of a thin credit history rather than troubled finances. If you have a lot of cash on hand, a down payment bigger than the standard 20% will often persuade a lender to approve your home loan.

Ready to make your move?

With so many options available to you, buying a home has never been easier. By increasing your credit score and choosing the most suitable loan, you’ll be a homeowner in no time.

Need a trusted real estate agent? As the principal realtor of Windseeker Realty, Jenna Galegher has deep expertise in Wisconsin’s Bayfield region. She can also connect you with trusted mortgage lenders who can provide the funding you need no matter what your credit score may be.

Get in touch with Windseeker Realty, one of the top real estate companies in Northern Wisconsin, at 715.779.500 You can also send us an email at Agent@WindseekerRealty.com