The better your credit, the more affordable your loan could be

Your credit score plays a crucial role in achieving various financial milestones, and purchasing a home is no exception. There isn’t a single credit score to aim for, but having a better credit score can make your loans more affordable. Lenders usually charge higher interest rates to people with lower credit scores while offering lower rates and better terms to those with higher scores.

Your credit scores are important for reaching many financial goals, including buying a home. When you apply for a mortgage, lenders consider your credit scores, among other factors, to decide whether to approve you for a mortgage. Your scores also influence your mortgage rate.

What credit scores do you need to buy a house?

Although no single credit score guarantees approval for a mortgage, there is a standard range of scores for different types of home loans. Each lender can set its standards, so even if your credit scores are good enough on paper, they may not be enough to qualify with the lender of your choice.

Conventional loans

A conventional loan is one that isn’t part of a mortgage loan program through the federal government. Conventional loans can be either conforming or nonconforming. A conforming loan meets standards set by Fannie Mae and Freddie Mac, companies chartered by the U.S. government to provide affordable mortgage financing to borrowers. A nonconforming loan doesn’t need to meet those standards.

Fannie Mae requires that homebuyers have credit scores of at least 620 (for fixed-rate mortgages) or 640 (for adjustable-rate loans) to qualify for a conforming loan. While it may be possible to qualify for a nonconforming loan with scores less than 620, only a small percentage of homebuyers have lower credit scores, and those loans tend to have higher interest rates.

FHA loans

FHA loans, guaranteed by the Federal Housing Administration, offer a chance for individuals with lower credit scores to purchase homes. According to the FHA Lender’s Handbook, the minimum credit score required to obtain an FHA loan is 500, but you’ll need a down payment of at least 10%. To qualify for the lowest down payment of 3.5% with an FHA loan, you’ll need a credit score of at least 580. Additionally, there may be additional lender requirements.

VA loan

The Department of Veterans Affairs guarantees a VA loan and is available to military veterans and uniformed service members who have fulfilled specific service requirements. Unlike other loan programs, the VA loan program does not have a minimum credit score requirement set by the Department of Veterans Affairs. Instead, lenders can establish their own minimum credit score requirements. However, it is common for lenders to ask for credit scores of 620 or higher for these loans.

USDA loan

USDA loans are designed for low-to-moderate-income households residing in rural areas. The USDA offers two loan programs. In one program, the U.S. Department of Agriculture guarantees loans provided by approved lenders. In the other, the USDA lends the money directly. While there are no USDA-established minimum credit scores required to borrow, there are income eligibility rules. It is possible to earn too much money to qualify for a USDA mortgage.

What do lenders consider besides credit scores?

Remember that your credit scores are significant, but they’re not the sole factor lenders take into account when you apply for a mortgage. Lenders also consider several other factors when determining whether to approve your mortgage application, the amount you can borrow, and the potential interest rate.

Debt-to-income ratio

Remember that your debt-to-income ratio is the percentage of your gross monthly income that goes toward debt. Some lenders may require that your DTI be no higher than 36% for conventional loans, but it may go up to 45% for borrowers who meet other credit score and cash reserve requirements. Different lenders may have varying tolerance levels for debt ratios. According to the Consumer Financial Protection Bureau, getting a qualified mortgage is a “more stable” and affordable mortgage loan, even with a debt-to-income ratio higher than 43%.

Down payment

The amount of down payment required varies depending on the type of loan and your financial situation. VA and USDA loans allow you to purchase a home with as little as 0% down. Some conventional mortgage programs may require a down payment as low as 3%. Typically, a down payment of at least 20% is needed for conventional mortgages to avoid private mortgage insurance.

Cash reserves

Lenders require borrowers to have savings in place when purchasing a home to ensure they can properly maintain the property and continue making payments in case of income disruption. Acceptable cash reserves may include money in checking or savings accounts, the value of financial investments (e.g., stocks and bonds), vested retirement account funds, and the cash value of vested life insurance policies.

The amount of cash reserves needed to qualify for a mortgage depends on various factors, including your debt-to-income ratio (DTI) and the size of the down payment you can provide.

Employment history

When purchasing a home, lenders need to ensure that you have a reliable source of income to make your loan payments. Typically, lenders prefer that you have at least two years of employment income, although they may approve someone with just one year of employment if they are confident in the stability of your income.

It is generally necessary for self-employed individuals to demonstrate two years of earnings. However, lenders may make an exception for borrowers with at least one year of self-employment income if they previously worked in a similar field and have maintained a stable or increasing income.

Can I buy a home with bad credit?

Lower credit scores may not prevent you from purchasing a home, but you will likely face other challenges in the process.

First, individuals with lower credit scores typically receive higher interest rates, which can result in significant additional costs over the duration of the loan. Even a one percentage point difference in the interest rate can lead to thousands of dollars in extra interest payments over the life of the loan.

Another potential outcome of having a lower credit score is that the lender may require a larger down payment. For instance, while an FHA loan allows borrowers to secure a loan with as little as a 3.5% down payment if their credit score is 580 or higher, those with credit scores below 580 must provide a minimum of a 10% down payment.

What’s next?

Your credit scores play a crucial role in lenders’ assessment of your mortgage application. Different types of home loans have varying credit score requirements.

No matter what kind of loan you’re applying for, having a higher credit score is advantageous not only for getting approved for the loan but also for securing the lowest interest rate and most favorable loan terms. If you’re considering purchasing a home in the near or distant future, now is an ideal time to begin improving your credit health to enhance your chances of loan approval.