Purchasing a new home is an exciting time, but getting bogged down in the numbers can make the process confusing and stressful. Realtors and lenders regularly talk about credit scores and interest rates, and while many people are familiar with these terms, their connection to each other while purchasing a property is not always clear.
Your credit score is a number that reflects your creditworthiness, and while credit scores factor into everything from credit cards, insurance rates, and utilities, they are most critically used for large loans to purchase items like cars or houses. Generally, the better your credit score, the more secure a borrower you are, and the lower your interest rate will be. Ideally, you want a high credit score that will not only increase your borrowing opportunities, but also lower the interest rate on the loan you receive. Since a lower interest rate means smaller payments, you may want to know how the two correlate.
A credit score is measured on a scale from 300 to 850, and they are generated from three main credit reporting companies: Equifax, Experian and TransUnion. To establish your score, these companies factor in your history of payments, your outstanding debt, the length of your credit history, the type of credit you use, and how much of your current credit is new or if you’ve recently inquired about new credit. Lenders typically look at the scores presented by each company and focus on the median score of the three.
By looking at information like credit scores, lenders can ascertain what interest rate would be appropriate. If your lender feels like you’re at a higher risk of missing payments, they may offer you a higher interest rate. For example, let’s say that you have a good credit score, and your lender is comfortable with offering you a large loan at a low-interest rate. You borrow $200,000 on a 15-year mortgage with a 3.5% interest rate, creating a monthly mortgage payment of $1,430*.
On the other hand, let’s say you have a poor credit score that puts you in risky territory. You borrow $200,000 on the same 15-year mortgage, but you are offered a 4% interest rate instead. Your monthly payment on the same property is now $1,479*, or $588 extra a year.
This example is also relevant when it comes to selling your property down the road. When you have a lower interest rate not only are your monthly payments lower, but the amount of equity that goes into the home from each monthly payment is higher. When you have a lower interest rate you pay more monthly for less equity. Therefore, if you have a lower interest rate, the amount you pocket from the resale will be higher, as you have paid more towards principal instead of towards interest.
A credit score isn’t everything when it comes to a mortgage, and lenders can and do look at other parts of your profile to see how risky you might be as a borrower. But this is the exception rather than the rule. When borrowing for a mortgage, your credit score is the foundation that your home purchase is built on, and a good credit score will save you thousands on interest alone.
If you’re concerned that your credit scores could negatively impact your interest rates in buying a home, there are steps you can take to significantly increase your ability to borrow money at better rates. Start by checking your credit score at AnnualCreditReport.com. If you’re unsatisfied with your score, there are reputable credit repair services available to get you on the right track.