Relationship Between Credit Scores and Mortgage Rates

By Brandon Cornett
© 2011 All rights reserved

How important is your credit score when shopping for a mortgage loan? How does your score relate to the interest rate you receive from the lender? These are some of the questions we will address in this video lesson. Click the "play" button below to get started. You can also read a transcript of this video by scrolling down below the player.

Video transcript: Today we're going to talk about the relationship between credit scores and mortgage rates. In particular, I want to show you a real-world scenario where having a better credit score could say you a lot of money.

In this video, we have two separate home buyers named John and Jane. John has a FICO credit score of 790, which is pretty good. Congratulations, John. Jane's score is also good, but a little lower than John's. She has a FICO credit score of 640.

You actually have more than one FICO score, because there's more than one credit-reporting agency. But to keep things simple, we'll just say that these numbers reflect their average credit scores. Both of these home buyers are paying one point of prepaid interest, which means they're paying one percent of the loan amount at closing in order to secure a lower interest rate. They're both making a 20-percent down payment on their mortgage loans. And they both have favorable debt-to-income (DTI) ratios -- let's say less than 35 percent DTI.

Both home buyers are getting a 30-year fixed-rate mortgage in the amount of $250,000. So they both have the same size loan and similar qualifying criteria, with one exception -- John has a higher credit score than Jane.

Higher Credit Scores = Lower Interest Rates

So John, because of his superlative credit score, gets a 4.5 percent interest rate on the $250,000 mortgage loan. Jane gets assigned a 5.5 percent interest rate. This is still a good rate (by 2010 standards), but obviously not as good as John's.

So here we have a one-percent difference between the mortgage rates on the two loans. How does this affect the mortgage payment, if all other factors are equal? John's mortgage payment comes out to around $1,266. Jane's payment comes out to $1,419.

Now let's assume they both stay in their homes (and keep their mortgages) for the full 30-year period. How much will they pay in interest over that 30-year term? John will pay more than $206,000, just in interest. Jane will pay around $261,000 in interest. This is not the total amount of money they're going to pay -- this is just the interest.

At the monthly level, there's a $153 difference between what John is paying and what Jane is paying. Jane is paying $153 more per month, due to her higher mortgage rate. Over the 30-year term, Jane is paying almost $50,000 more than John -- because her interest rate is one percent higher than John's rate. And this all ties back to the credit score. With all other factors being equal, the higher credit score got John a better mortgage rate.

This is why credit scores are so important for mortgage shoppers, and why it's important to get the best interest rate possible. You might not think there's a big difference between 4.5 percent and 5.5 percent. But the example above shows how much money it could save you on the monthly level, and also over the term of the loan. What could you do with an extra $153 per month, or an extra $50,000 over the 30-year life of the loan? So it does make a big difference.

These numbers are based on a one-percent difference between the two mortgage rates. You can imagine how these two numbers would spread even further apart if there was a two-percent difference between the two interest rates. So a lower rate is definitely worth pursuing, and one of the ways you can do it is by boosting your FICO credit score.

Granted, the credit score is not the only factor that influences your mortgage rate. In the video, we discussed some of the other important factors as well. These include the size of your down payment, your debt-to-income ratio, and the amount of prepaid interest (points) you pay at closing. But as the video explains, the credit score is one of the strongest factors that can determine your mortgage rate.

Would you like to learn more about this topic? We have dozens of articles on this website about credit scores and mortgage rates. If you need some advice on improving your FICO score, check out our library of credit articles. If you want to learn more about home loans, check out this section of our website. I hope this article helps you understand the relationship between credit and mortgage rates. Good luck with your home buying process.