How your credit score changes the cost of a mortgage

An excellent credit score can save you tens or even hundreds of thousands of dollars in interest on a typical mortgage. Because a mortgage is one of the largest and longest loans most people take on, lenders use your credit score as a key measure of the risk that you will not pay them back. A lower score signals higher risk, which lenders offset by charging you more interest. This results in a higher monthly payment and a dramatically higher cost over the life of the loan.

A worked example: the dollar cost of a lower score

To see the real-dollar cost of a credit score, consider two borrowers applying for the same 30-year fixed-rate mortgage. Both are buying a $400,000 home and making a 10% down payment, leaving them with a loan amount of $360,000. The only significant difference is their FICO credit score.

• Borrower A has an excellent credit score of 780.
• Borrower B has a fair credit score of 650.

Lenders offer different interest rates to these two borrowers based on their perceived risk. For this example, say Borrower A qualifies for a 6.5% interest rate, while Borrower B is offered an 8.0% rate. The difference in their payments and total costs is stark.

The borrower with fair credit pays $366.11 more every month. Over 30 years, that adds up to $131,798.73 in extra interest payments. That is money that could have gone toward retirement savings, education, or other financial goals, but instead goes directly to the lender, all because of a lower credit score.

How lenders see your credit score

A credit score is a number that summarizes your history of paying back debts. To a lender, it is a direct forecast of how likely you are to default on a loan. A mortgage is often the largest single debt a person takes on, and it is a long-term commitment, so lenders are especially careful. They manage their risk by charging higher-risk borrowers a higher interest rate.

The most widely used scores are from FICO. You can learn more about the components in our guide to what your FICO score actually measures, but they are calculated using five main factors, as published by the company:

• Payment history (35%): A consistent record of on-time payments is the most important factor.
• Amounts owed (30%): This looks at how much you owe across all your accounts. Key factors include your credit utilization ratio on revolving accounts and the total amount of your debt.
• Length of credit history (15%): A longer history gives lenders more data to assess your reliability.
• New credit (10%): Opening several new accounts in a short period can be a sign of risk.
• Credit mix (10%): Lenders like to see experience managing different types of credit, like credit cards and installment loans.

Because mortgage debt is so large, even a fraction of a percentage point on the interest rate, compounded over three decades, creates a huge difference in total cost.

What is a good score for a mortgage?

While it is possible to get a mortgage with a lower score, you will not get the best terms. FICO defines its score ranges as follows: 800+ is “Exceptional,” 740-799 is “Very Good,” 670-739 is “Good,” 580-669 is “Fair,” and below 580 is “Poor.” You can see where you stand in our guide to what is a good credit score.

To qualify for the best mortgage rates on a conventional loan, you typically need a score of 740 or higher. Government-backed loans, like those from the Federal Housing Administration (FHA), have more lenient requirements and are available to borrowers with scores in the 500s, but they come with their own costs, chiefly mortgage insurance premiums (MIP). If your down payment is less than 10%, this insurance lasts for the life of the loan. If you put down 10% or more, it is cancelled after 11 years. Regardless of the loan type, the rule is universal: a higher credit score gets you a lower interest rate.

The difference between interest rate and APR

When you shop for a mortgage, you will see two numbers: the interest rate and the Annual Percentage Rate (APR). They are not the same.

The interest rate is simply the cost of borrowing the principal amount. The APR is a broader measure of the loan’s cost. It includes the interest rate plus other finance charges, such as lender origination fees, discount points, and some closing costs. Because it includes more costs, the APR is usually higher than the interest rate and gives a more complete picture of what you are paying. Under federal law (Regulation Z), lenders must disclose the APR, so you can make an apples-to-apples comparison between loan offers. You can learn more about how these two figures differ in our guide to APR vs. interest rate.

How to prepare your credit for a mortgage application

If you plan to buy a home, preparing your credit well in advance can save you a fortune. Start at least six months to a year before you apply.

1. Check your credit reports. Federal law gives you the right to a free credit report from each of the three major bureaus (Equifax, Experian, and TransUnion) every year at AnnualCreditReport.com. The bureaus have also made free weekly reports permanently available. Review each report for errors.
2. Dispute any inaccuracies. If you find an error, like an account that is not yours or an incorrect late payment, dispute it with the credit bureau. The bureau generally has 30 days to investigate under the Fair Credit Reporting Act. An incorrect negative mark can be a major drag on your score.
3. Pay down credit card balances. Your credit utilization ratio is a major scoring factor. Most scoring models have no “memory” for past utilization, so paying down high balances right before you apply can provide a significant and immediate boost to your score. Aim to get your utilization on all cards below 30%, and into the single digits for the best results.
4. Do not open new credit accounts. Applying for new credit generates a hard inquiry on your report, which can temporarily lower your score by a few points. Avoid applying for new credit cards or loans in the year before you seek a mortgage. The one exception is rate shopping for the mortgage itself. FICO scoring models have a deduplication window (usually 45 days) that treats all mortgage inquiries within that period as a single event, so you can shop for the best rate without hurting your score.
5. Pay every bill on time. Payment history is the single most important part of your credit score. One late payment can stay on your credit report for seven years, so ensure every account is current and stays that way.