March 16, 2021
Saving for a house is a big step in your financial future. It typically requires pulling together a down payment and qualifying for a mortgage. However, having debt can limit how much of a mortgage you qualify for. What’s more, you may find yourself in a bit of a Catch-22 as you balance saving for a down payment with paying off what you owe. Luckily there are steps you can take to increase your chances of qualifying for a mortgage or help you improve your terms and interest rates, including improving your credit score. Here’s a look:
Your credit score is one factor that lenders will look at when considering whether to offer you a mortgage. Your score is based on your credit history, which includes information about the types of credit accounts you have and your payment history. It helps lenders figure out how likely you are to repay your debt on time — i.e., how risky you are.
Typically, lenders will use your FICO® Score, which grades an individual's credit on a scale from 300 to 850. Generally speaking, the higher your score, the less risk you present to lenders. With a higher score, lenders may offer you better terms and lower interest rates on a mortgage.
Here’s a breakdown of what your credit score might signal:
800 or higher: An exceptional score that demonstrates to lenders that you are a very low credit risk.
740 to 799: A very good score that is above average for U.S. consumers and demonstrates dependability when paying back loans.
670 to 739: Most lenders will consider this a good score, and it’s about average for U.S. consumers.
580 to 699: A fair score that is below average. Many lenders will still approve loans for consumers with this score.
580 or less: A poor score that indicates a borrower may be a credit risk. Lenders may not approve a loan for a consumer with this score, though some options exist.
When making lending decisions, lenders can vary in how they consider risk and what level of risk they find acceptable. While some may use the guideline above, others may have different strategies.
The credit score you’ll need to secure a mortgage will depend on what type of mortgage you’re applying for. The good news is you don’t have to have a flawless score to qualify for a loan, though you’ll likely need one of 580 or greater. With that score, you can apply for a Federal Housing Administration (FHA) loan designed to help lower-income consumers buy a house by offering low down payments, low closing costs and easier credit-qualifying standards. You can actually qualify for an FHA loan with a credit score as low as 500, but you’ll need to make a down payment of at least 10% for scores less than 580. Otherwise, you only need to put down 3.5%. Note, that lenders can impose their own credit limits for FHA loans. So while 500 may be the floor, they may, in fact, require scores well over 600.
To qualify for a conventional loan that’s backed by Fannie Mae or Freddie Mac you’ll need a FICO score of at least 620. VA loans for veterans typically have similar requirements.
If you find yourself with a credit score that’s too low to secure the loan you want, there are a number of ways you can improve your score. Requesting a free credit report is a good first step to take. The three major credit reporting bureaus, Equifax, Transunion and Experian, are offering free weekly credit reports through April 20, 2022, in response to the Covid-19 pandemic. Make sure everything on the report is correct, alerting the bureaus right away if changes need to be made.
Your payment history is the most important factor in your credit score. Setting up automatic bill pay will ensure your bills are paid on time and you never miss a payment.
The next most important thing you can do to boost your score is lowering the amount of debt you’re carrying. One tactic is focusing on paying off high-interest credit card debt as quickly as you can, as these debts likely cost you more than lower-interest loans, such as student loans or automobile loans.
Keeping your credit utilization ratio — the amount of debt you carry compared to your credit limit — to 30% or less is recommended. Consumers with the highest credit scores have a credit utilization ratio in the single digits. Getting your debt under control shows lenders that you are responsible with your credit, potentially prompting them to offer more affordable mortgage options.
A larger down payment helps you minimize the size of your mortgage loan and can mean lower monthly payments. It may also translate into a lower interest rate, which means spending less on interest payments over the life of the loan.
If you want to rein in your debt while saving for a down payment, establishing a budget is key. The basics of budget building starts with calculating your monthly after-tax income. Next, tally up all your necessary expenses—things like rent, utility bills, insurance, transportation, and food. Subtract this amount from your income, and the difference represents your discretionary income. These are the funds you can use for savings, debt payments, vacations, entertainment, and other categories.
Using this pool of cash to pay off your high-interest rate debts first is a good option for tackling debt. Determine how large an extra payment you can make while also setting aside money for a down payment. If you want to pay off your debt fast and don’t mind waiting to buy a house, prioritize a larger extra payment. You may find some wiggle room in your discretionary spending by cutting back on non-essentials like eating out. That extra cash could be put toward your savings goals or your debt repayment plan.
If debt has you strapped for cash, or you can only afford a small down payment, there are programs that can help. While the general rule of thumb is to aim for a 20% down payment, an FHA loan, as discussed above, only requires 3.5% down. Conventional loans have a 3% minimum, and there are even some loans that allow you to put 0% down.
A small down payment means you potentially may be able to buy your house sooner, but there are some drawbacks. If you put less than 20% down, your lender may require you to purchase private mortgage insurance, which protects the lender if you can’t make your payments. You’ll also have less equity in your home, which can make it harder to secure some types of loans that are backed by collateral.
If you’re ready to start saving for a home and want to reduce your credit card debt, Tally may be able to help. Learn how you may be able to pay off your debt faster, so you can build your credit, save more, and accomplish your goal of buying a house.