Stefanos Chen Jun 24th 2010 1:33PM
Jul 18th 2011 1:59PM
Jennifer Labin was coming up on the seventh year of her adjustable rate mortgage when she decided it was time to try to lower her interest rate. Jennifer and her husband had lived in their Maryland townhouse for the better part of a decade. But with a bigger family on the way and the interest rate on their ARM about to jump, they knew it was time to find a home (and a mortgage interest rate) that better suited their needs.
With a fixed-rate mortgage in mind, the couple went in search of the best interest rate they could find. And if there's one thing savvy buyers should avail themselves of, it's how to read their credit report.
With a FICO score of 720 or above, you're in a position to get the best mortgage interest rate, and in turn save hundreds of dollars a month on loan payments. But it doesn't pay to obsess about achieving a perfect score once you're in the upper echelon. Instead, to reap the full benefits of being a low-risk borrower, it's important to understand what considerations go into your credit score, and how lenders interpret the data to determine your mortgage interest rate.
Mortgage Interest Rate and Credit Scores
Often referred to as a FICO score (for the Fair Isaac Company, which created one of the best-known credit formulas), the score measures a combination of how regularly you pay your bills, live within your means, and manage debt. Of all the considerations, lenders pay closest attention to your history of payments, says David Jones, president of the Association of Independent Consumer Credit Counseling Agencies. "If there was one thing I'd tell consumers, it's to pay every bill on time," Jones says. "Do it religiously and don't make minimum payments." It may sound obvious, but the key to a low interest rate is credit score stability, and creditors' priorities reflect that. While different reporting agencies may vary slightly in the how they weigh the various factors (FICO is not the only measurement used by the three major credit bureaus), credit scores are based on five key elements: Paying bills on time: 35% Debt-to-credit-limit ratio: 30%
How long you've had the credit: 15%
Pursuit of new credit: 10%
Types of credit used: 10%
Have 6 Months of Stable Credit History for a Lower Interest Rate
To present a picture of financial stability, Jones suggests that homebuyers take at least six months to get their finances in order before applying for a mortgage in order to get the best mortgage interest rate. In this economy, risk managers are looking in the strangest places to analyze your spending habits -- including the grocery line. "If you never buy your groceries with a credit card, and then you suddenly start using it, that's a red flag," Jones says. Some of his clients were surprised to find that their interest rates had gone up because of changes in their spending patterns. And while something as mundane as grocery shopping may not directly affect your mortgage interest rate, he says that an accumulation of such minor discrepancies could hurt a lender's faith in you.
Unfortunately, stability can come at a high price, as even some positive changes in your finances can shake your lender's confidence. Part of what goes into the credit algorithm is the time you've spent working at your job. So while changing jobs for a pay raise might seem like a no-brainer, if you're expecting to apply for a mortgage within the next year, you may want to hold off until you've secured a good mortgage interest rate.
Keep a Low Debt-to-Credit-Limit Ratio
You should never use more than 50 percent of your total credit limit, says Dorothy Guzek, a financial counselor for GreenPath Debt Solutions. a nonprofit credit counseling agency. In fact, she says, using 40, 30, or even 5 percent is even better. In other words, the total debt you owe on any account should never approach the total credit limit. This is because credit formulas divide the sum of your balances by the sum of your credit, and use this number to judge how well you live within your means. Just because you have a high credit limit doesn't mean you should prove that you need all, or even most of it. Mortgage lenders see such spending as the sign of a high-risk borrower and therefore set higher mortgage interest rates for frequent offenders -- if they lend to them at all.
Opening and Closing Accounts
At the same time, don't panic and start shuffling cards in an attempt to artificially change your ratio -- you'll only cause more damage and potentially hurt your chances of getting a
low mortgage interest rate. Closing credit cards without a balance, for instance, reduces your total credit limit, and therefore worsens your debt-to-income ratio. If you close your oldest card, your credit history becomes younger, which hurts your long-term reliability. Finally, if you open up new cards in the six months prior to applying for a mortgage, it suggests to lenders that you're having trouble paying bills and that will also ding your score. So, serial shoppers should beware of department stores that offer membership credit cards in exchange for discounts. These too can prevent you from getting a low mortgage interest rate when applying for a home loan.
Diversify Your Credit History
One way to help ensure you'll get the best mortgage interest rate is to show your lender that you can handle a variety of loans, including fixed payments (mortgages, car payments, student loans) and revolving credit (credit cards). The best way to stay current with your balances is to sign up for automated bill payment. Provided you haven't charged more than you're capable of paying, you'll never suffer another late payment again.
There are some individuals with credit scores in the high 700s, says Jones, who won't qualify for the best mortgage interest rate because of past indiscretions on their credit report. In a growing number of cases he's seen, larger landlords are reporting their tenants' rent-payment records. "Any creditor can deal directly with the three major credit bureaus," Jones says. So treat your landlord like you would your lender. By the same token, if you always were on time with rent payments you should request that your landlord submit a positive report to the credit bureaus; it will make you more appealing to lenders, especially if you don't have very established credit.
Beware "Credit Repair"
"When you hear someone say they can improve your credit in a short period of time, you oughtta run for the hills," says Jones. While some people have tried to game the system and artificially inflate their credit score in the hope of getting a lower mortgage interest rate, these efforts are usually made in vain, and for a hefty fee. "It's not just the FICO score. Lenders look at the credit report [when deciding the mortgage interest rate]," he says. It's more important to avoid behavior that indicates job loss, or some other financial instability. Throughout the plodding process of preparing one's credit, patience is a virtue. There is no substitution for establishing a long track record of reliability.
Get Your Credit Report and Check for Errors
The federation of U.S. Public Interest Research Groups found that 79 percent of credit reports have a serious error or other mistakes, and one in four reports has an error so bad that it could prevent someone from getting credit at all -- let alone a low mortgage interest rate. To prevent this from happening to you, visit AnnualCreditReport.com. the only site sponsored by the three credit bureaus, and note any errors you find. You are entitled to an annual free report from each of the three credit bureaus: Experian, TransUnion and Equifax. To track your score over time, while also searching for discrepancies between the three reports (as they each use slightly different formulas), Guzek suggests staggering the reports over the course of the year -- one every four months.
The Final Test
It took Jennifer and her husband about seven weeks from start to finish to move into their new home -- an impressive feat, considering that the average home purchase takes about four to five months. If there's anything Jennifer would share with prospective homebuyers hoping for a low mortgage interest rate, it's to remember that "affording a new home means a lot more than paying the mortgage."
One way to test whether you're ready to make the move, says Guzek, is to determine just how much you'll be spending monthly in addition to your mortgage payments. Once you've added up your projected mortgage payment and all your other budgetary items (be honest), put this money aside for three to six months in a savings account. If you find that you need to dip into it for emergencies, you can't yet afford your new payment, she says. But if you can comfortably get by without touching the account, you're not only ready for your mortgage, you've also built up a handsome hunk of change toward your down payment.
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