Your credit score and debt-to-income ratio have a big influence on your home loan options and rates. Learn how lenders use them, as well as how you can improve them.
Interest rates vs. APR
An interest rate is the cost of borrowing money shown as a percentage. For example, if you borrow money at a 5% fixed interest rate for a year, the cost of the loan will be 5% of the total amount you borrowed.
Some factors that help determine an interest rate include:
Length of the loan term (for example, 30 years vs. 15 years)
Your loan amount compared to your home's value
How you plan to use the home (primary residence, secondary residence or investment/rental property)
Your credit score
Property type (single family, condo, co-op , townhome or multi-family)
Mortgage loan type (for example, FHA, VA, conventional or jumbo loans)
The Annual Percentage Rate (APR) is the total cost of borrowing money for a mortgage. It's shown as an annual rate and includes certain closing costs, interest, finance charges and points over the full loan term.
The APR helps you compare different mortgage options, because all lenders calculate the APR according to federal requirements. Lenders are also required by law to provide the specific APR for your mortgage in the Loan Estimate.
The impact of your credit
A good credit score makes it easier to qualify for a home loan—at a lower interest rate.
Your credit score shows your overall credit history and helps lenders decide if you qualify for a loan. The higher your credit score, the more mortgage options available to you and the more likely you'll qualify for a lower interest rate.
When you apply for a mortgage, your lender looks at your credit score from the 3 major credit agencies: Equifax, Experian and TransUnion, usually taking the middle score for your application. If you are applying with another person, the lender will take the lower, middle score of the 2.
Credit scores generally range from 300 (lowest) to 850 (highest). For most lenders:
700 or above is a "good" score.
620 and under could make it hard to qualify for a conventional mortgage but there are still options available.
You can access the 3 major credit agencies online to check your credit report and score. If you find any mistakes that need correcting, it's best to contact the credit agency as soon as possible.
How is your credit score calculated?
Credit agencies typically take these 5 things into account when calculating your credit score:
Consistently paying your debts on time every month generally gives you a higher credit score.
The less debt you have, compared to your total available credit, the higher your score.
Types of credit in use
The number and types of accounts in your name, such as credit cards, retail accounts and car payments, are listed in your credit report. Lenders also consider whether you're a joint account holder or an authorized user of an account.
Length of credit history
The amount of time since your accounts opened and the last time you used each account is factored into your credit report. The longer your established history, the higher your score.
New credit accounts and inquiries
Every time you apply for credit or open a new account, an inquiry is added to your report. The more inquiries you have, the lower your score. Activity on joint or co-signed accounts will also affect credit scores. For example, if you co-sign for a relative and they default on their payments, both scores are affected.
Having a lower debt-to-income ratio can help you qualify for the mortgage loan you want.
Your debt-to-income (DTI) ratio is the percentage of your monthly gross income that goes toward paying debts. The lower your DTI ratio, the more likely you are to qualify for a mortgage. Lenders include your monthly debt expenses and future mortgage payments when they consider your DTI.
Calculating your DTI
You can find your DTI ratio by dividing your debt by your income.
For example, if your monthly income is $4,000 and your monthly debt expense plus future mortgage amount is $1,320, your DTI ratio is 33%. Most mortgage options have specific DTI ratios.
The preferred DTI ratio is generally around 36%. You can reduce your DTI ratio by limiting your credit card usage and paying down your existing debt.
Depending on the available rates for your mortgage, you may be able to pay mortgage points to lower your interest rate.
Mortgage points are fees that you can pay to lower your interest rate or closing costs.
There are 2 types of points:
Depending on available rates for your mortgage type, you could pay mortgage points to lower your interest rate.
1 point costs 1% of the loan amount
1 point typically lowers your interest rate between from .250 and to .375%, depending on your mortgage option
You could also get credit against closing costs, known as rebate points, by paying a higher interest rate. The amount of the credit against your closing costs and increase in your interest rate depend on your mortgage option.
Is paying mortgage points right for you?
The longer you plan to stay in your home, the more likely you'll benefit from paying points.
To decide if paying points is right for you, you can calculate the "break-even point" or how long it would take for the cost of the points to equal your total savings.
Finding your break-even point
Calculate your monthly payment at the interest rate you'll be charged without points.
Calculate your monthly payment at the lower rate with points.
Subtract the amount in Step 2 from the amount in Step 1 to find your monthly savings.
Calculate the cost of the point(s) you would purchase.
Divide the amount in Step 4 by the amount in Step 3.
The result is the number of months you'd need to live in your home to break even on the amount you paid for points.
$100,000 loan — 30 year term
5.5% interest with no points = $567.79 monthly payment
Buying 1 point to lower your interest rate by .25% = a monthly payment of $552.20
Monthly savings = $15.59
1 point = 1% of $100,000 = $1,000
$1,000 / $15.59 = 64 months
In this example, it would take 64 months for you to regain the cost of paying points. If you don't plan on staying in your house for that long, paying points might not make sense.