How do credit scores affect mortgage rates? To put it simply, lenders charge higher interest rates on borrowers with lower scores, and vice versa. It has to do with risk. After all, that three-digit number is basically a risk indicator.
This tutorial explains the inverse relationship between credit scores and mortgage rates, and how they apply to you as a borrower.
As always, we will start with some basic definitions:
- Credit Score — This is a three-digit number that indicates how a consumer has borrowed and repaid money in the past. It is computed from the information found within a person’s credit report. Mortgage lenders use these scores when qualifying borrowers for home loans, and also when assigning interest rates. They also use them as a risk-assessment tool, as explained below. There are many different types of credit scores. FICO and VantageScore are the two most commonly used by mortgage lenders.
- Mortgage Rate — This is the amount of interest charged on a home loan, generally expressed as a percentage. Lenders assign interest based on several factors, but risk is chief among them. Mortgage rates can either be fixed (unchanging) or adjustable.
- Risk-Based Pricing — This is a method used by lenders when deciding how much interest and fees to charge on a particular loan. Rates are assigned partly based on the borrower’s likelihood of default, as measured by the lender. If a borrower is considered to be a higher risk of default, the lender will charge a higher mortgage rate to compensate. Risk is measured by credit scores, debt ratios, loan types, and down payment size.
So you can begin to understand how your credit score affects the mortgage rate you receive on a home loan. Lenders use these three-digit scores to assess the level of risk associated with each borrower. Based on their assessment, they will charge a certain amount of interest, which may be higher or lower than current average mortgage rates. This is the fundamental concept of risk-based pricing.
Granted, the credit score isn’t the only factor that influences the mortgage rate. But it is one of the most important factors.
Meet John and Jane, Mortgage Shoppers
This will all make more sense if we plug in some actual numbers. Here is a real-world (and highly realistic) scenario that shows the relationship between credit scores and mortgage rates.
I would like to introduce John and Jane, two unrelated home buyers:
- John has a FICO credit score of 805, which is pretty darn good. Congrats, John!
- Jane has a FICO credit score of 660. It’s a decent score, but clearly lower than John’s.
Both of these home buyers are paying one point of prepaid interest, which means they are paying 1% of the loan amount at closing in order to secure a lower interest rate.
Both buyers are making a 20% down payment on their mortgage loans. And they both have favorable debt-to-income (DTI) ratios, less than 35% on the back end.
Both borrowers are getting a 30-year fixed-rate mortgage in the amount of $250,000. So they both have the same size loan and similar qualifying criteria, with one key exception — John has a much higher FICO number than Jane.
How will their credit scores affect their mortgage rates, and the overall cost of borrowing? Let’s take a look…
Higher Credit Scores = Lower Mortgage Rates
Because of his excellent credit, John secures a 4.5% interest rate on the $250,000 mortgage loan. Jane is assigned a rate of 5.5% on her loan. The lender views her as a higher risk and charges more interest to compensate. So clearly, her credit is affecting the cost of borrowing. She is paying more interest than John, as a result of having a lower score.
So here we have a difference of 1% between the mortgage rates on these two loans. How does this affect the monthly payments, when all other factors are equal?
- John’s monthly payment comes out to around $1,266.
- Jane’s monthly payment will be approximately $1,419.
Now let’s assume they both stay in their homes (and keep their mortgages) for the full 30-year repayment period. How much will they pay in interest over the full 30-year term?
- John will pay approximately $206,000 in interest.
- Jane will pay approximately $261,000 in interest.
Note: This is not the total amount of money they will pay over 30 years. This is just the interest.
So Jane is paying $153 more per month than John. This is due to the higher mortgage rate assigned to her loan, which is a direct result of her lower FICO number. Over the full 30-year term, Jane would pay $55,000 more than John. With all other factors being equal, a higher credit score brings a better mortgage rate — and lower interest costs.
At first glance, you might not see a big difference between 4.5% and 5.5%. But the example above shows how much money it could save you at the monthly level, and also over the term of the loan. What could you do with an extra $153 per month, or an extra $55,000 over the 30-year life of the loan? Your credit score could make all the difference.
These numbers are based on a mere 1% difference in mortgage rates. You can imagine how the cost gap would grow even wider if there was a 2% difference between the interest rates.
Conclusion: Key Points for Home Buyers
We’ve covered a lot of information up to this point, so let’s recap some of the key points:
- Credit scores are three-digit numbers computed from the data found within consumer credit reports.
- Lenders use these numbers to measure the level of risk a borrower brings to the table.
- Credit scores directly affect mortgage rates. Lenders charge more interest for riskier borrowers.
- This is known as risk-based pricing. The higher the risk, the higher the cost for the borrower.
Granted, credit scores are not the only factor that affect the interest rate. Lenders also consider the size of your down payment, your debt-to-income ratio, and the amount of prepaid interest (points) you pay at closing. But credit scores influence mortgage rates the most, so they deserve your full attention.
This leads us to a follow-up question: How do you maintain a high score? You can start by paying all of your bills on time, and using credit sparingly. These two factors have the biggest impact.
Disclaimer: This article explains how credit scores affect mortgage interest rates during the lending process. Please note that every lending scenario is different because every borrower is different. Despite the length of this article, we have only scratched the surface of risk-based pricing and interest charges. We encourage you to continue your research on (and beyond) this website.