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How Does Your Credit Score Affect Mortgage Approval?
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Each year thousands of prospective homeowners are shocked to discover their credit history will keep them from their dream of home ownership. While it may seem surprising that an individual could know so little about their own credit score, the truth is that far too many consumers go blithely through life, unconcerned about how their financial actions my effect their future plans. While consumers may be aware there are a few spots on their credit score, they do not realize the full impact their actions have and the adverse effects until they are denied a loan. If asked what they thought their credit score to be, consumers generally respond they believe their credit score to be fair or good. In reality those same consumers have absolutely no idea what their credit score is because they have not taken the time to run a credit check or to research the qualifications for having an excellent, good, fair or poor credit rating.
While each credit reporting bureau has their own standards and formulas that they use for the purpose of calculating mortgage shopper's credit score, below is a generalized breakdown of what it takes to hit each benchmark on a credit report.
- Excellent credit rating - No late payments, no collection notices, no bankruptcies or repossessions.
- Good credit rating - May contain a late payment within the last two years.
- Fair credit rating - More than one late payment. May or may not have a bankruptcy or repossession in the last two to three years.
- Poor credit rating - Recent collection attempts, late payments within the last year, bankruptcies and/or repossessions within the last two to three years.
The effect each credit rating can have on a consumer's life is the difference between being approved for loans and being denied approval. Even when a consumer gains seemingly instant approval, if their credit is less than excellent, they will find themselves paying far more interest than a consumer with outstanding credit. This is because lenders base the interest rates offered to consumers on the basis of how much risk the borrower presents.
Since individuals with less than perfect credit traditionally present more of a risk of defaulting on a loan, lenders are able to justify charging more interest to those consumers. The extra interest the lender earns on the loan is intended to compensate the lending agency in the event the consumer defaults on the loan. Over the course of a 15 or 30 year mortgage, those extra interest points can add up to an astounding amount of money.
But, wait a minute, you might be thinking. If I default on the loan, the lender can take back the property, sell it and still recoup their money. While technically, this is true; this will only occur after the lender has spent significant out of pocket expense in trying to collect money due from the borrower as well as whatever various legal fees may be involved in forcing a repossession. The interest money helps to alleviate the out of pocket expenses paid by lenders who have to force collection and repossession.
Besides higher interest rates, consumers with splotchy credit may find that banks are not willing to finance as much of a purchase as they would be if the consumer had better credit. Again, this relates to the subject of risk. A lender would rather reduce their risk by having the borrower fund a larger percentage of the purchase. Banks that might would otherwise finance almost 100% of a home purchase will suddenly drop their offer to 80% or 90% when a credit check reveals a poor credit rating. In order to purchase the home, the consumer will need to come up with the remaining funds out of pocket and that means a considerably larger down payment. Unfortunately, in some circumstances the extra money required on the down payment prevents consumers who are already strapped for cash from being able to buy a home.
The best course of action a consumer can take to fight negative impacts by their credit score is to be constantly vigilant. Pay bills on time, monitor your debt load constantly and don't shift money around from one account to another. Make a habit of saving all receipts in case a dispute arises and ends up on your credit report. A borrower's financial health should receive a yearly checkup. Staying on top of your credit history by running a credit check once a year will help you to discover problems while they are fixable; and not when you are sitting in front of the loan officer.
Debt Advice by Ellise Walsh
Mortgage and Finance Industry Columnist
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