How credit scores affect how much interest you pay

This little number makes a big difference in how you will be able to finance your home purchase.

What is your credit score?

Your credit score is a number generated by factors present in your credit report, a record collected by a credit reporting agency. Most credit reports and scores are supplied by one of the three major national credit reporting agencies (Experian, TransUnion, and Equifax), and while each uses a slightly different methodology and range to calculate, they all rely on software developed by Fair, Isaac, and Company (FICO). These credit scores are referred to as FICO scores. FICO scores range between 300 and 850. The higher your credit score is, the more responsible you have been with your past credit, and the more likely that you will be able to receive favorable terms on new credit.

The information on your credit report that determines your credit score includes your payment history (whether you have paid your bills on time), outstanding debt (whether you are overextended in your ability to repay what you have already borrowed), the length of your credit history (how well-established you are as a borrower), the types of credit you use (a “healthy” mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans) and new credit (whether you have recently taken on new obligations).

Credit Scores and Your Mortgage

Your credit score affects your ability to obtain future credit, whether that takes the form of a credit card, auto loan or a home mortgage. If your credit score is particularly low, it indicates to a lender that you are a credit risk, and that they should either take additional precautions when lending you money or decline to lend you money at all. In terms of a home mortgage, your credit score affects the kind of mortgage you’ll be able to obtain and what kind of rates and fees will be attached.

Homebuyers with good credit ratings will have access to Conforming Conventional Mortgage Loans, also known as prime rate loans or “A” loans. These mortgages have the best rate of interest a lender has available according to market conditions, and are made by for-profit lenders without insurance from the federal government.

For buyers with low credit ratings, meanwhile, there are Subprime Loans, used by lenders when buyers cannot qualify for prime loans. These loans rely on risk-based pricing, which determines your interest rate and fees based on a complex computerized evaluation of your specific circumstances and the likelihood that you will default on (or fail to pay) your mortgage. Subprime loans have a grading system developed by lenders, which range from A- to D. The lower your credit score is, the lower grade loan you will qualify for and a higher interest rate and fees will apply.

While subprime loans are pricey, they are not necessarily predatory and can be a legitimate way for someone with a low credit score to obtain home financing. However, it is a fine line, and you must shop carefully and watch out for outrageous fees and unfair terms. Also, it is important to consider other options that may be available to you, including FHA (government insured loans) and Michigan State Housing Development Authority (MSDHA) loans which are specific programs for low-income or first-time homebuyers.

Improving Your Credit Score

Fortunately, it is possible to improve your credit score. Often your credit report will highlight problem areas that can be addressed in your particular circumstances. According to Gwendolyn Miller, Michigan State University Extension housing counselor, “You can improve your credit score by correcting inaccurate information, paying bills on time, and minimizing outstanding debt as well as new credit accounts, opening them only as needed and to pay off responsibly as a means of re-establishing credit.”

Remember you are entitled to a free credit report from one time each year from each of the three credit-reporting agencies. There is a lot to sort out, but by keeping on top of your debts and being informed of your credit score, you are well on your way!

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