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Source: 401kcalculator.org via flickr
While it's certainly true that you can buy a home with a less-than-perfect credit score, you may be surprised at how much of an impact a small difference in your score can make over the life of a 30-year mortgage. And, if you know how the credit scoring formula works, improving your score and saving thousands on your next home purchase might be easier and faster than you might think.
Small interest rate differences can add up to big savings
In general, lenders want to see a minimum FICO credit score of 620 to obtain a conventional mortgage loan. However, to obtain the best interest rates, you'll probably need a 760 or higher.
Let's consider an example of a buyer who wants to borrow $250,000 to purchase a home. Based on the national average interest rates, here's how much of a difference their credit score will make over the long run:
|FICO score range||Average interest rate (APR)||Monthly mortgage payment||Total interest paid|
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Source: www.myfico.com, data current as of 6/1/15
As you can see, there is a significant difference between each of these thresholds. A borrower with a 710 FICO score could expect to pay more than $9,000 less over the life of the loan than someone with a 695.
Now, dramatic improvements in credit usually don't happen overnight, but it might be possible to get enough of a quick boost to save you serious money. To understand how, let's take a look at how the FICO scoring formula works.
Five weighted categories make up your score
Your FICO credit score is made up of five distinct categories of information, each of which has its own weight.
- Payment history (35%)-- The largest contributor to your credit score is whether or not you pay your bills on time. If you do have late payments, they'll gradually become less of a factor in your score as they age, and will fall off completely after seven years. This category also includes derogatory items such as collection accounts, judgments, and bankruptcies.
- Amounts owed (30%)-- This is somewhat misleading, because the actual dollar amounts you owe aren't as important as how much you owe relative to your credit limits and original loan balances. Also included in this category is the number of credit accounts that have a balance, and the types of balances you carry (credit cards, installment loans, etc).
- Length of credit history (15%)-- Basically, the longer your credit history, the more confident lenders can be about your future credit behavior. This category takes into consideration the average age of your accounts, the age of your oldest and newest accounts, and how long specific accounts have been established.
- Types of credit used (10%)-- Lenders feel that they can get a better understanding of your credit habit if you have experience with more than one type of credit accounts. A healthy mix of accounts (mortgage, loan, credit card, lines of credit) can be a positive factor in your score.
- New credit (10%)-- Applying for too much credit in a short period of time is considered a negative factor in your credit score. This category takes into account how many of your accounts are new, as well as the number of credit inquiries you've had in the past 12 months.
The best way to improve your score quickly
Obtaining a top-notch great credit score is a gradual process, and there really isn't much you can do to improve your payment history or the length of your credit history in a short period of time. However, there are a few things you can do if you're looking to boost your score by a few points, particularly in the "amounts owed" category.
By far, the number one way to improve your credit score quickly is to pay down your credit card balances, if you have any. Experts generally recommend to keep your total credit usage under 30% of your total available credit. So, if you have $10,000 in total credit limits, aim for $3,000 or less.
Moving your remaining balances to just one card could also boost your score. Often, you can do this with pretty good balance transfer offers, so you could also save on interest by doing this. Remember, part of the "amounts owed" category comes from how many of your accounts have balances, so $2,000 in credit card debt spread across five accounts could be worse than carrying the same balance on a single card.
If you have no credit card debt, you could also potentially get a boost by paying a little extra on your other loan accounts, like a car loan.
Remember, a few points could go a long way
Even if you can boost your credit score by just enough to take you to the next level; it could easily save you thousands of dollars over the life of your mortgage. And, if you boost your score by paying down credit card debt, you'll save money on interest there as well. The long-term benefits certainly outweigh the short-term financial burden of accelerated debt repayment, so if you're in the market for a mortgage, paying down some of your debts is definitely a plan worth considering.
The article The Easy Way to Save Thousands on Your Next Home originally appeared on Fool.com.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.