September 18, 2010

Can a low credit score sink your mortgage?
  • Consumers need good credit scores to get top mortgage rates.
  • Risk-based pricing determines how much you'll pay.
  • Borrowers with poor credit should consider FHA loans.

Does a low credit score mean you can't get a home mortgage?

Since 2007, when Freddie Mac and Fannie Mae introduced "risk-based pricing," consumer credit scores have played an increasingly pivotal role in the mortgage application process.

"Fannie Mae and Freddie Mac looked at credit scores and loan performance and realized that borrowers with lower credit scores are far more likely to default on their loan than borrowers with higher scores," says Douglas Benner, a senior loan officer with Embrace Home Loans in Rockville, Md.

How credit scores change mortgage payments
Credit scoreRate*Monthly payment
on $300,000 home
760-8504.072 percent$1,445
700-7594.294 percent$1,484
680-6994.471 percent$1,515
660-6794.685 percent$1,553
640-6595.115 percent$1,632
620-6395.661 percent$1,734
*As of Sept. 14, 2010
Source: Research Services

As a result, credit score requirements are now stricter. Consumers need high scores to qualify for the lowest mortgage rates, says Gibran Nicholas, chairman of The CMPS Institute, an organization in Ann Arbor, Mich., that trains and certifies mortgage bankers and brokers.

"Consumers with a score as low as 620 can sometimes qualify for conventional financing, but they will pay a higher interest rate and points," Nicholas says.

What's a good score?

FICO generates the most widely used credit scores, which are based on credit reports from three credit reporting agencies: TransUnion, Equifax and Experian.

"FICO scores rank-order consumers by how likely they are to pay their credit obligations as agreed," says Craig Watts, public affairs director for FICO.

Nicholas says a credit score of 740 is the threshold for qualifying for the best interest rates from conventional mortgage lenders.

"Typically, risk-based pricing tiers shift about every 20 points. So if your score is 680, you may need to pay 1.5 points at the closing or a higher interest rate," Nicholas says.

"If your score is 640, you will need to pay 3 points at the closing. On a $400,000 loan, that means you could need $6,000 or $12,000 extra."

Consumers can choose to pay points or a higher interest rate.

Benner says borrowers with a score in the mid-600s will likely pay 0.75 percent higher interest than the lowest current rates.

PMI and credit scores

Conventional loan borrowers who make a down payment of less than 20 percent also need to meet private mortgage insurance guidelines in addition to qualifying with the lender.

Here again, credit scores make a big difference in a borrower's ability to secure a mortgage.

"Most PMI companies will not approve a loan for anyone with a credit score below 680," Benner says. "In addition, the amount of the loan they will insure changes based on the credit score. On some properties, such as a cash-out refinance or a second home, the PMI companies insist on a credit score of 720 or higher."

Nicholas says that in a declining market where home prices are still dropping, such as Michigan, PMI companies can require a credit score of 720 or higher.

How to overcome poor credit

Benner says borrowers with credit challenges should apply for FHA-insured loans.

"While FHA has not yet set a minimum credit score, most lenders will only qualify borrowers with a score above 620 and some have even set the minimum for FHA loans at 660," Benner says. "My company is one of the few that goes down to 540, but this depends on the consumer meeting other guidelines such as a reasonable debt-to-income ratio and savings."

The FHA has proposed limiting loan approvals to borrowers with credit scores of 500 and above and to require a 10 percent down payment from borrowers with credit scores between 500 and 579.
Another proposal would require borrowers with a credit score below 620 to have cash reserves of at least one month's mortgage payment available following the closing. Nicholas anticipates these changes to be in place in early 2011.

Borrowers who are turned down for an FHA loan through their automated system can request manual underwriting so that a live person reviews their loan application, Nicholas says.

"Be prepared with a letter of explanation for your low credit score, such as a one-time event or illness rather than a pattern of not paying your bills," Nicholas says.

Nicholas says if one lender won't do manual underwriting, another might.

Other compensating factors that can help a borrower overcome a low credit score include a low debt-to-income ratio, stable employment and substantial savings.

Benner says that FHA loans are available to all borrowers regardless of income or whether they are first-time homebuyers, as long as the home price meets area loan limits.

Another way to qualify for a mortgage when you have poor credit is to make a larger down payment.

"If you can put down more than 20 percent you won't have to meet PMI requirements," Benner says. "You may need to pay extra at the closing or a slightly higher interest rate, but you can qualify for a loan."