Credit: it’s one of the modern economy’s biggest driving forces, allowing people to buy cars, start businesses, and acquire homes without having to supply the cash out of pocket. Since credit is so important to the way people do business with one another, it’s essential to have a standardized way to gauge a person’s creditworthiness. That’s where a credit score comes in. A person’s credit score is a measure of how long and how responsibly they’ve used the credit available to them, as judged by the three major credit-rating agencies. The score, which typically falls between the 300 and 800, can affect the terms of auto loans, credit cards, and the biggest loans most people will ever take out: mortgages.
Credit’s Affect on Mortgage Interest Rates
Assuming someone’s credit history isn’t so shaky that they’re denied financing entirely, having a bad credit score can make for equally bad mortgage terms. For example, for a hypothetical borrower with a credit score of 620 a mortgage might come with an interest rate of 6.2 percent; for a borrower with credit scores nearer to 700, interest rates on a large loan would likely fall well under 5 percent. (Mortgage rates shift all the time, so these are relative figures.) It’s easy to see, then, why boosting your credit score before you apply for a major loan makes sense.
So Why Does Interest Matter?
A few extra percentage points of interest might not sound like much, but on loans the size of mortgages, those points matter—a lot. Rather than building up over time, interest is figured into payments from the outset of the loan, so it directly increases the price of each month’s installment.
As examples, let’s use two hypothetical home buyers, named George and Will, who are both going to take out a mortgage loan. George, who has excellent credit, gets a 4% rate on his $500,000, 30-year mortgage. Will, whose credit isn’t so great, manages to get a 6% rate on a loan for the same amount over the same time period. George’s monthly payment, according to Bloomberg’s mortgage calculator, would be $2,387. Will’s, on the other hand, would be a whopping $2,997—a difference of $610 per month. That amount over 30 years come out to a gap of $219,600. Will would spend nearly a quarter of a million dollars more than his counterpart George over the life of their loans.
Credit’s Effect on Mortgage Insurance
Your credit score also affects how much the lending institution tacks on to cover mortgage insurance–plans that help the bank recover if a borrower defaults on their loan. Risky borrowers cost more to insure, so a poor credit score may lead to the bank charging more for a beefier insurance policy. Having a good credit score can mean saving hundreds each month on hidden insurance costs built into the terms of your loan.
Help! My Credit Stinks
If you’re worried that your credit rating is too low to land an attractive mortgage deal, there are several steps you can take to boost your credit score. Making monthly payments on time is the foundation of every good credit score; consistent, regular payments will build good credit and can even help keep an ailing credit score from sinking lower while helping it start to bounce back. Demonstrating financial responsibility with installment loans is a good way to raise your credit score.
Lowering the percentage of your credit limit that you actually use is an often-overlooked but effective step: In the eyes of credit-rating agencies, someone who uses 20% of their maximum credit is probably more responsible than someone who consistently uses 95%. Having a lot of available credit shows both that the person doesn’t impulsively spend up to their limit, and that he or she has a cushion available for emergencies. This means that it might actually improve your credit score to open up a new line of credit, especially if you only use it to make small purchases that you know you’ll be able to pay off on time. So even if your credit score is low, there are still effective measures to improve your credit score, which will ultimately help you save money on your mortgage.