Purchasing your first home is a major milestone that requires careful planning and preparation. For those who want to finance their home purchase with a mortgage, it’s important to understand the significance of having a good credit score. A first-time homebuyer’s credit score can affect whether they qualify for a home loan and how much they’ll need to pay in interest. Although there are no hard-and-fast rules about the allowable credit score for a home loan, you will have a more difficult time finding a lender if your score is below a certain level.
Mortgage Loans for First-Time Buyers
A mortgage is one of the largest loans the typical consumer takes out. It usually is paid back over a period of 15 to 30 years with monthly payments that include both principal and interest.
Most lenders require a borrower to make a down payment of at least 3.5 percent and up to 20 percent or more of the home price, before they begin paying down the mortgage. Paying more as a down payment is a good idea since it decreases the amount of the mortgage loan, but it’s not always possible for first-time buyers.
Many first-time buyers find it more difficult to find a mortgage with a low down payment and acceptable interest rate because they don’t have an established credit history that would give them a high credit score. In this case, they may qualify for a loan insured by the Federal Housing Administration.
How Lenders Use Credit Scores
Your FICO credit score quickly tells lenders how risky it will be to give you a loan. It’s based on your past bill payment history, your current level of outstanding debt, the types of credit accounts you have and the number of accounts that have been recently opened.
Credit card debt, car loans, student loans and other types of consumer debt all play a role in determining your credit score. The majority of mortgage lenders use a consumer’s FICO score when deciding if they qualify for a home loan. Although your credit score is important when applying for a mortgage, especially if it’s the first time you’ve taken on major debt, lenders will also look at your employment history and current income when deciding if you qualify.
Credit Score to Buy a House
FICO credit scores range from 350-850 points, with higher scores indicating less credit risk for lenders. Mortgage reforms that were put in place following the housing market crisis of 2007 and 2008 make it more difficult for consumers with low credit scores to qualify for home loans. As of 2018, a FICO score of at least 580 is needed for an FHA loan, while a conventional loan requires a score of at least 620.
FHA Credit Score Requirements
Home loans insured by the FHA are part of a federal program aimed at making it easier to for prospective homeowners to qualify for home loans. Both FHA- and Veterans Administration-insured loans require down payments that are typically substantially less than the 20 percent required by many traditional lenders.
In the case of a VA loan, no down payment is required. No minimum income level is required to qualify for these loans, but you do need to make enough to afford monthly mortgage payments for the home you buy.
A credit score of at least 580 is recommended when applying for an FHA loan, though you may be able to obtain one with a lower credit score if you make a down payment of 10 percent or more.
Who Qualifies for an FHA Mortgage?
Many first-time homebuyers take advantage of FHA mortgages, but they are available to all home buyers who are buying their primary residence. Because people with lower credit scores may qualify for an FHA loan, they are sometimes referred to as “bad credit loans.”
They are easier to get than conventional home loans because the loan is guaranteed by the FHA, which means if the homeowner defaults on the loan, the FHA will take over the payments.
People who have a high ratio of debt compared to their income may qualify for this type of loan. Even people who have had a previous home foreclosure or a recent bankruptcy may be able to qualify for an FHA loan if they have maintained a good credit history since then. There is no limit to how many FHA loans you can take out in your lifetime, but you can only have one active at a time.
Credit Score for Conventional Mortgage
If you’re applying directly to a bank or other lender for a mortgage, you should have a credit score of at least 600. Even this score is considered only fair by most lenders. A score above 700 is preferable and will probably qualify the borrower for a lower interest rate on their mortgage. Those with scores above 740 can expect to be offered the lowest rates by mortgage lenders, also known as prime mortgage rates.
Bad Credit Mortgage Loans
When a conventional mortgage is given to someone with a credit score lower than 600, it is referred to as a subprime mortgage. Someone with a lower credit score who only qualifies for a subprime loan represents a greater risk for lenders, so subprime mortgages usually come with interest rates that are higher than the prime lending rate.
A subprime mortgage may have a fixed or variable interest rate. It may have a longer term for repayment compared to a prime mortgage, such as 40 or 50 years instead of 30. This may mean lower monthly payments for the borrower, but it also means that interest is being paid for a much longer period of time.
Someone with a low credit score who is considering a subprime mortgage should first find out if they qualify for an FHA mortgage or a prime mortgage with a different lender.
The U.S. government recognizes that the high cost of home ownership makes buying a home impossible for many people. The Federal Deposit Insurance Corporation allows borrowers to apply for interest-only mortgage payments on some home loans.
With this type of loan, the borrower is only required to pay only the interest on the loan each month for a specified number of years, after which payments for both principal and interest begin. These loans offer a short-term solution but can cause financial hardship when the interest-only period ends and loan payments increase, often substantially.
Improving Your Credit Score
Before you start shopping for a home loan, it’s a good idea to request a free copy of your credit report (many banks now offer free reports to customers). If your score falls into the poor or fair range due to a high amount of outstanding debt, especially credit card debt, consider paying it down before you apply for a mortgage.
Also be sure to clear up any debts that have gone to collection or any misinformation on your credit report that could keep you from qualifying for a mortgage.
It may be that your credit score is low because you have a short credit history. In this case, obtaining a credit card that you use occasionally and pay off each month can help establish your credit history. If you succeed in raising your score, be sure to maintain your higher score while shopping for a home and home loan to ensure you get the most mortgage possible.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.