Buying a home is part of the American dream. You’ll get a rush of excitement as you close on the deal, and you now have your first official asset in life.
For many Americans, homeownership is a priority, with the average age of first-time homeowners in the United States being 32-years old. These homeowners also earn an average of $72,000 per year.
However, many first-time homeowners have no idea of how to go about purchasing the real estate. Many Americans are clueless about the paperwork process and legal regulations regarding real estate sales. As a result, many Americans rely on real estate agents to handle the deal, and most never even think to negotiate the asking price or inquire about a down payment.
When a bank qualifies you for a home loan, they take into account several financial factors. You’ll need to have some form of verifiable income that shows you can pay for the mortgage installments. You’ll also need a down payment that’s equivalent to around 5-percent of the purchase price.
Next, the bank looks at your credit score to determine the risk in loaning you money. The banks rely on a credit score generated by the three credit bureaus in the US – Experian, Equestrian, and TransUnion. These bureaus collect data on your credit from reporting agencies like banks and retail outlets.
They collate your data and issue you with a FICO score that’s between 300 and 850. People that have a credit score under 520 are subprime borrowers, while those individuals that have a 700-score are an average risk, and those with an 800+ score are prime borrowers.
Your credit score determines whether the lender will provide you with a mortgage, and at what interest rate they will loan you the money. If you have a subprime credit score, most lenders won’t consider you for a mortgage. If you do secure a facility, you can expect it to have unfavorable terms and rates attached.
Average lenders with scores around the 700-mark receive good deals, but those with an 800+ score have the best positioning to secure the best terms and rates on their mortgage.
Banks and Risk – The 2008 Subprime Mortgage Crisis
Banks use the credit score system to avoid default by customers that can’t afford to pay their mortgage. Before the Great Financial Crisis of 2008, lenders would write up mortgages for anyone that wanted a home. The lending regulations allowed anyone to purchase a home, regardless of their credit score.
While this economic period saw one of the biggest booms in history, it soon fell apart. Loan originators were writing loans for people with no income, low credit scores, and no collateral. The lenders used adjustable mortgages and predatory lending strategies to write as many mortgages as possible to increase their commissions.
As a result, many people invested in real estate who could not afford to do so without the assistance of adjustable mortgage rates. Many of these homeowners were not aware that the interest rates charged on their mortgages were adjustable. As a result, when the interest rates adjust to normal market conditions, the homeowners suddenly find themselves underwater with their loan.
This financial catastrophe led to foreclosures all over the country, with millions of people losing their home because of irresponsible lending practices employed by the banks and loan originators. This mortgage crisis sparked the onset of a more profound financial crisis that almost sank the world economy.
As a result of the fallout from the Great Financial Crisis of 2008., lenders tightened regulations and lending criteria in the mortgage market. Banks started employing the use of FICO credit scores to check the risk profile of customers to ensure they could afford to pay the mortgage. The market stabilized in the aftermath of the crisis, thanks to more stringent qualifying criteria for acquiring a home loan.
How Do Lenders Measure Your Credit?
Lenders measure your credit suing the FICO system. FICO consists of five weighted benchmarks that contribute to your overall credit score.
How much outstanding credit you own – This is a measure of all your credit facilities, including credit cards, home loans, and student loans.
How much of your credit facility is in use – Banks don’t like to see you using more than 30-percent of the credit that’s available to you. If you have a credit card with a facility of $10,000, the bank doesn’t want to see you use more than $3,000 in credit.
Your payment history – This factor is the most significant contribution to your credit score. How you pay your creditors, and if you pay on time is a huge factor in this part of the credit score criteria.
Credit history – How old are your credit facilities?
Credit mix – Banks want to see a combination of credit facilities, including credit cards, auto loans, and personal loans.
Your statistics within these five criteria determine your credit score. Banks take credit scores very seriously, and if you are in the subprime category, you may find it challenging to secure a mortgage from a bank. You may have to go to a private lender to secure the deal, and that may come with high-interest rates and unfavorable terms to the agreement.
Why Is Your Credit Score Important When Buying a Home?
Your credit score is vital when acquiring a mortgage. Banks rely on your credit score to check the risk in loaning you money. The more risk the bank sees in the deal, the higher the interest rate charged on the mortgage. Therefore, if you have a good credit score, you can expect to receive the best interest rates on your home loan.
Interest rates are the primary concern of any new homeowner. If you secure a mortgage with a 4-percent interest rate, it will save you thousands of dollars over the lifetime of the loan, when compared to an interest rate of 3-percent. A single percentage point makes a massive difference in your monthly payments. Therefore, new homeowners need to search for the best interest rates possible.
By increasing your credit score, you make yourself a lower risk to the bank when lending money for a mortgage. We outlined a few strategies to help you improve your credit score and get a better deal on your mortgage.
Strategies to Improve a Good Credit Score
If you have a credit score in the upper 700s, then try to chase that revered 800+ mark. By increasing your credit score into the 800s, you get the best rates on your mortgage. An 800+ score puts you at the top of the heap, and lenders will fall over themselves, trying to secure your business.
With an 800+ score, you have access to the lowest lending rate reserved by banks for its best customers. You may even secure a rate that’s below the prime level, leading the thousands of dollars in savings over the lifetime of your home loan.
People with a credit score in the upper 700s don’t need much to elevate their score into the 800s. Start by examining your credit facilities. The credit utilization ratio is where most people with a high credit score are failing. Are you using more than 30-percent of your credit? If so, scale back until you reach the 20 to 30-percent level and keep it there for 12-months.
Strategies to Improve an Average Credit Score
People who have an average credit score between 680 and 750 are also in an excellent position to apply for a mortgage. However, if you can lift your score a few points, it will help you secure a better interest rate with the banks when applying for your mortgage.
Review each of the five weighted factors for determining your credit score, and look at where you can improve. Typically, people who have an average credit score lack in two or three areas that are holding them back from achieving a score in the 800s.
The most common areas to focus on are your credit utilization ratio, as well as your credit mix. Make sure you have several sources of credit, and that they are all paid on time every month. Download your credit score and look for any outstanding payments from creditors that could be diminishing your score.
Strategies to Improve a Subprime Credit Score
People with a subprime credit score are in the worst position when applying for a mortgage. Back in 2008, it was subprime lenders along with unethical lending practices that sparked the onset of the greatest financial calamity in human history. Therefore, banks are hesitant to loan to subprime borrowers.
People with a subprime credit score need a financial overhaul. It’s a prudent strategy to meet with a financial advisor. They can help you map out where you are spending your money, and what you can do to increase your income and savings. Take a few classes on financial management and learn how to build a budget.
Download your credit report from one of the three bureaus, and look for any collection notices or judgments. If you do have either of these blemishes, then contact the creditor and make arrangements to settle your debt.
Work on the other 5-areas of your credit report for at least one to two years, and you should see significant improvement in your score.
What to Do If You Have No Credit History
People that have no credit history may find it challenging to secure a home loan. If the bank has no history of your spending habits and no proof of income, then they are unlikely to offer you a mortgage. Many students are in this position, as well as people that are new to the job market.
These individuals are getting their feet wet in the financial world, and many of them don’t have any credit facilities. Fortunately, the credit bureaus realized the need for an update to the FICO scoring system and introduced the VantageScore 3.0 credit system as a complimentary credit score alongside the traditional FICO system.
VantageScore allows you to build your credit score quickly. In some cases, it’s possible to get yourself into a credit-worthy position in less than 6-months.
How to Check Your Credit Score for Free
Checking your credit score is easy. Each of the three credit bureaus allows you to request one free credit report annually. If you spread out your requests, then you can get a credit report for free every 4-months.
Some banks and financial institutions also make your credit score readily available on your credit card statement. Others allow you to check your credit score through the online banking portal as well.
There are private websites where you can check your credit score for free as well. Sites like Credit Karma offer users a free credit report if they leave their basic information on the site. These websites make money by pushing advertising onto you as you visit the site and download your score.
In some cases, you may not know your credit score. Upon downloading your credit report, you find that you are a victim of cybercrime where someone else steals your identity and makes loans on your name. If you are a victim of this scam, contact the credit bureaus and your bank for advice.
Wrapping Up – Key Takeaways
Buying a home is the birthright of every American, but fewer people can afford a home than at any point in the nation’s history. The Great Financial Crisis of 2008 led to a near-collapse of the global economy. As a result of the crises, banks tightened lending regulations and criteria for mortgages.
Banks rely on your credit score to determine the risk involved with loaning you money. The lower your credit score, the higher the risk for the lender. Mortgages in the subprime category typically come with unfavorable terms and interest rates to prevent the borrower from accessing the finance they require.
Fortunately, there are steps you can take to improve your credit score before you apply for a loan. By tightening up your credit score, you get preferential rates on your mortgage, saving you thousands of dollars over the lifetime of the loan.