How Your Credit Score Impacts Interest Rates

Your credit report plays a major role in the interest rates you qualify for when you apply for a home loan. A good credit score could save you a lot of money in mortgage interest charges over the life of your new loan or refinance.

Credit Scores Affect Interest Rates

I saw this first hand last week when I was pre approved for a home loan by a local bank. When the mortgage officer pulled our credit report I expected my credit score to be around 750 so I was pleasantly surprised when it was over 800.  They ran a credit check with each major credit bureau (Equifax, Experian, and TransUnion) and picked the middle score, which put me above 800.

Many lenders use a tiered pricing approach where you get the best interest rates when you have a high credit score, maybe 770 and above, but the rate you pay to borrow goes up as your credit score goes down.  Since I was over 800, instead of 750 where I had projected, that put us into the best interest rate tier.

Checking Your Credit

Fortunately for me, it was a good surprise but to avoid any bad surprises you might want to get your free credit report before you start applying for pre approval so you know if you need to do anything to fix your credit first.

The online credit report from Annual Credit Report won’t tell you your score but it does give you a chance to look at the details behind what could be giving you a poor credit rating.  If you want to check your credit score so you know where you stand there are a few different options. 

• Sites like Credit Karma will show you a version of your credit score online, it’s not your fico score but it can give you a rough idea.
• myFICO has a credit score estimator that asks you a series of questions and based on your answers estimates what your credit score will be.
• Experian offers a $1 credit report and credit score that converts into monthly credit monitoring after the 7 day trial at FreeCreditReport.
• Equifax gives you your credit score and a credit score report for $12 with ScoreWatch.

If after you view your credit report you aren’t where you need to be for a good interest rate there are things you can do to improve your credit score and rebuild your credit.  Of course it takes time for the credit reporting agencies to pick up your changes, lenders typically don’t report payments to them more than once a month.

Credit Scores & Home Loans

As I mentioned above, a good credit score can qualify you for a lower interest rate; on a big loan like a mortgage that lower rate can save you thousands of dollars.

Your credit score can also have an impact on what price home you’re able to afford.  One of the scoring factors that lenders look at is your Loan to Value ratio or LTV.  This ratio shows the relationship between the dollar amount you’re borrowing and the value of real estate you’re buying.  The higher the ratio, the more risk the bank is taking to lend you the money.

For example, if you want to buy a house appraised at $120,000 and need to borrow $110,000 (an LTV of 91.6%) that means you’re only putting down a $10,000 down payment.  On the other hand, if you had an LTV of 75% that would mean you put down $30,000 and the bank takes less risk.

Your credit score matters because banks are more likely to approve a loan with a higher LTV ratio if you have good credit.  If you don’t have much money for a down payment and you have a bad credit score, the bank might only approve a smaller loan, which means you’ll have to find a lower priced house.

One thing to keep in mind is that look at factors other than credit score, another big one is your debt to income ratio or DTI.  Your DTI is a measure of your monthly debt payments (student loans, mortgages, car loans, credit card debt) compared to your monthly income. 

Fixing Your Credit Score

There are a variety of steps you can take to fix your credit but it’s difficult to know what improvements each action will make to your overall score.  If you want to do some “what-if” analysis, myFICO has a credit score simulator that lets you enter a variety of scenarios such as on time bill payment, paying down credit card balances, opening credit lines, and missing payments to see how they might affect your credit score.

Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn't like the other kids... His addiction to personal finance has paid off for his family and now he's helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.

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