It’s a Friday night around 9:30 and you’ve been playing major catch up on your favorite Hulu show. During the commercial break, you get up to grab a snack when one of those credit score commercials comes on. Normally you roll your eyes and walk away, but tonight, something in the commercial flips a switch in your brain. Your pringle is frozen mid-air and you start to panic.
Your credit score.
You realize you have no idea what your credit score is. Suddenly, you feel a cold sweat form on your brow as every late bill and careless purchase of your adult life floats to mind. Your dream of a house with a white fence and a three car garage flashes before your eyes as you imagine the worst about your credit score.
The commercial ends and you can breathe again, but then you realize you have a lot of unanswered questions. What IS a credit score? What does the number even mean? How important is a credit score to a mortgage? Am I doomed forever if I have a bad credit score? Where do I even start?
Great questions. And we have answers.
What is a credit score?
First, it’s helpful to understand why credit scores even exist. When you borrow money from a bank or other lending company, they see you as a potential investment. They make money on the interest you pay them over the course of the loan, so, like any smart investor, they need to know if you’re going to make them money by consistently paying your bills, or cost them money by defaulting or even consistently paying your bills late. So the financial community devised a system to calculate whether or not you are going to be a sound investment — credit scores.
A high credit score means that, most likely, you’re reliable and financially stable enough to pay your bills on time and eventually pay off your mortgage. A high number tells a bank that, most likely, they won’t lose their money and will probably walk away with a net gain on their investment.
A low credit score, on the other hand, means you’re a riskier investment and may not give them the return they need. Depending on how low your number is, they may choose not to loan to you, or they may take other measures to ensure that they get paid back in some fashion. For example, they may increase your interest rate or require a higher down payment to protect them from any potential losses that may come their way.
What’s in a credit score?
Credit scores range from 300-850. There are actually thousands of systems to determine credit scores, but the one you’ve probably heard of the most is your FICO score. While banks often use their own methods for scoring, FICO is the Fannie Mae and Freddie Mac standard making it the most prominent. By the way, Fannie Mae and Freddie Mac are government-sponsored companies that buy loans from mortgage lenders, packages them together, and sells them as a mortgage-backed security to investors on the open market. To give you an idea of what a credit score is composed of, this is the FICO standard:
- Payment history – 35%
- Amounts of debt owed – 30%
- Length of credit history – 15%
- Types of credit variety/mix – 10%
- New credit – 10%
This means that paying your bills on time is most important to a good credit score, followed by low outstanding debt, having a long and consistent credit history, having a variety of credit (credit cards, student loans, mortgage, etc), and having a small amount of new credit.
How important is a credit score for my mortgage?
The interesting thing about credit scores is that they don’t necessarily indicate wealth. They simply prove that when it comes to loans, you have demonstrated the ability (or inability) to pay them off well.
There are lots of wealthy people who don’t have the credit history needed to determine how they interact with a loan. Since banks are aware of this, a lot of factors go into the home loan decision. Banks also seriously consider things such as your history with them, your income, overdrafts, average account balances, and even how much money you’ve put down on other loans with them in the past.
Of course, if those other factors are a little on the weak side, your credit score will mean a lot more. With a good credit score, you’re more likely to secure a better interest rate, a smaller down payment, and therefore, the potential ability to purchase a larger home or better property.
What does my credit score need to be to get a home loan?
It depends. And changes. At the moment, if your score is above 620 you open the door for nearly every available loan. If it’s under 620, you’ll have to look into other loan programs to see which one will fit your situation. You’ll need to contact a loan officer to give you your best options.
If I have a low score, am I doomed forever?
We’re happy to say, no! There are a lot of things that you can do, but not enough space to talk about them here. Check out the last post in our credit and mortgage series, to find exact steps you can take to improve your credit score.
If you have any questions or would like help with your credit score, we’re happy to help. Contact one of our friendly and knowledgeable lending agents to get all the answers you need.