Right now, a high credit score can mean getting up to 83 basis points shaved off your mortgage interest rate compared to people with lower scores. It’s a gap that is widening as the pandemic grinds on and credit standards for borrowers tighten.
A recent report by the Urban Institute shows that borrowers with scores above 720 are getting mortgage rates 78 basis points lower than folks with scores below 660. In the nonbank space, the spread is wider, as high-credit scores can knock off up to 83 basis points from mortgage rates.
Those basis points add up fast on a 30-year fixed-rate mortgage. If you borrow $300,000 at 3.5 percent, you’ll pay $1,347 a month and total interest of $184,968. But the same loan at 4.3 percent means a total interest of $234,461. That’s a difference of $49,493.
Lenders have always reserved the lowest rates for borrowers with high FICO scores, but the gap has gotten wider since the pandemic. This behavior is typical during downturns, says Michael Neal, senior research associate at the Urban Institute.
“We definitely saw that wide spread during the great recession. In 2008, the spread between low and high credit scores peaked at 62 basis points in 2008,” Neal says.
Not only did the housing crisis cue credit-tightening but it also prompted lenders to stop offering certain products, which we’re also seeing now. HELOCs, for example, which are loans collateralized by the borrower’s house, are starting to vanish from the market as lenders reduce their risk.
“Banks are also looking at cash-out refis and tightening the availability of those products. They don’t want to make risky loans,” says Ralph McLaughlin, chief economist at Haus. “Wells Fargo, as an example, wasn’t going to process jumbo refis unless the applicant had $250,000 in cash with Wells.”
Wells also announced this week it is suspending new applications for home equity lines of credit, following the lead of mortgage giant Chase Bank.
Why lenders are shrinking the credit box
Lenders are in a protective mode as unemployment numbers skyrocket. One way they can shield themselves from borrowers defaulting on their loans is to apply a credit overlay, which is an increase in standards beyond what’s required from government or GSE guidelines.
“Typically a loan servicer needs a loan to perform for at least three years so they can break even,” says Kevin Martini, senior mortgage strategist at Martini Mortgage Group at Benchmark Mortgage. “With the spike in unemployment, servicers fear they will not be able to service the loan long enough to break even because the borrower might lose their job, they can no longer pay the mortgage and the property becomes distressed.”
Since the credit score is one way lenders can suss out risk, they’re charging more for riskier borrowers in order to protect themselves if the loan runs into problems.
“The mortgage rate spread is saying you can still get a mortgage but you’ll have to pay a higher price for it. The next step is we’re going to restrict you from getting a mortgage if your credit score falls below a certain number,” Neal says.
Credit requirements hit some groups harder
Making loans more expensive and harder to get will have an effect on millions of borrowers.
“This is going to have an effect on African-American and Hispanic borrowers — people who disproportionately have not been able to benefit from homeownership because they have lower FICO scores,” Neal says.
This will also impact first-time borrowers who tend to be younger, earn less and have lower credit scores than their more affluent peers.
“We see a very strong correlation between credit scores and higher incomes. Borrowers with lower incomes, first-time buyers and younger borrowers also happen to be a bigger share of the job segment impacted by COVID-19. This will impact them for at least the next three to six months,” McLaughlin says.
Equity-rich homeowners can also be penalized during the pandemic if credit standards continue to rise, making it tougher to qualify for cash-out refinances.
“Homebuyers who have built up equity aren’t able to tap into it or will have to tap into it at a very high rate,” Neal says. “People who didn’t mimic the go-go years of housing refi and thus have a lot of equity won’t be able to access it now when they need it.”
Credit availability will stay where it’s at or even shrink if the economy continues to take hits from high unemployment, shuttered businesses and lower consumer spending.
“Whether the recovery will be ‘V-shaped’ or will it be ‘U-shaped’ is the thing to keep on the radar — once the servicers have the certainty that defaults are not a reality, I think it will go back to business as usual,” Martini says.
9 ways borrowers can raise their FICO scores
Borrowers who want to get a mortgage but have credit scores below 700 might want to wait on the sidelines while they improve their credit or they could face higher mortgage rates.
If you want to get a mortgage now with a sub-700 FICO score, shop around, says Casey Daneker, real estate agent at Keller Williams Realty, Inc.
“Yes, mortgage companies are tightening up their requirements for loans. Requirements for credits scores have already changed and some smaller lending companies are removing certain loans altogether. Now is the time to shop around and see who can provide you with the best options,” Daneker says.
For borrowers who can wait, this is a good time to work on your credit score. The higher your score, the lower your loan costs will be. Mortgage lenders typically look at credit scores from all three reporting agencies: Equifax, Experian, and TransUnion, and will use the middle score in determining your loan terms.
The first step in improving your score is to analyze what’s holding your score down, says Adrian Nazari, chief executive officer at Credit Sesame.
Federal regulations permit consumers to get one free copy of your credit report every 12 months from each of the three nationwide credit reporting bureaus: Equifax, Experian and TransUnion. Once you get your reports, you can see how different categories are affecting your score, including payment history, debt utilization, length of credit history, types of credit, and inquiries for new credit.
- 580 and below is considered poor
- 580-669 is fair
- 670-739 is good
- 740-799 is very good
- 800 and above is considered excellent credit
“Even a single error can lower your credit score, depending on what type of error it is, so the first step in fixing your credit is to discover and clear up any reporting errors,” Nazari says. “You can dispute an error with the credit bureau that issued the report, or you can dispute it with the creditor who reported the data in the first place.”
Once you clear up any errors on your report, you can systematically begin fixing some of the negative events.
Nazari gives insight into what mortgage lenders are looking for, what will impact your score the most and how borrowers can strategically attack their credit score to raise it as fast as possible.
1. Pay off delinquent accounts.
- Medical collections will not count toward your debt-to-income ratio.
- If you have a collection account that’s several years old, you might want to just wait it out and let it age off your report. That usually takes seven years and 180 days after the date of delinquency. Of course, aging off your credit report does not absolve you of responsibility for the debt.
2. Pay off more-recent collection accounts.
In the newest credit scoring models, paid collections are ignored but unpaid collections hurt your score. Recent collections hurt the most.
3. Monitor your credit to make sure the new data is reported.
New data is usually reported once a month, but some lenders will report it every 45 days.
4. Make all payments on time, every time.
Since payment history is the single biggest factor affecting your credit score, establish a perfect payment record for at least six months and preferably for two years or longer.
5. Pay down debt.
A high debt-to-income ratio is the biggest red flag in a new mortgage application. Even though it might not be possible for you to pay off all debt before applying for your home loan, you should bring it down as low as possible. That’s because mortgage lenders will examine your debt-to-income ratio, or DTI, to determine whether you will be able to afford your new mortgage payment.
6. Leave accounts open.
It may seem counterintuitive to leave credit card accounts open, especially after you pay them off, but that’s what you should do. This is particularly true if you still have debt on one or more other cards. It goes back to your credit utilization ratio. Remember, the less you owe in comparison to the total amount of credit available to you, the better your utilization ratio will be.
7. Avoid credit inquiries.
Too many inquiries may show that you’re desperate for credit or that you’re at risk for financially overextending yourself. Don’t apply for credit unless you need it. And definitely don’t apply in the six months preceding your loan application. However, you can shop for mortgage rates without worrying about multiple inquiries because the only way to compare loan offers is to apply with more than one lender.
8. Piggyback off your relatives.
Becoming an authorized user on someone else’s account, such as a parent or sibling means that you will automatically benefit from the age of their credit history. While the primary cardholder is still responsible for making the payments, you get to reap the benefits of building credit.
9. Monitor your credit.
You can use a credit monitoring service to catch any credit reporting errors and avoid surprises when you apply for a mortgage.