By Scott Sheldon -
Planning on getting a home loan anytime soon? Before you do, you should know that there are two types of loans that are inherently higher in cost than their traditional mortgage counterparts — and we’re not talking subprime or private money, either. Bottom line, if your credit score is below 680 or you have credit blemishes or little equity, it can drive up the cost of a mortgage.
This is why it’s so important to know what your credit score is before you shop for a mortgage. (One helpful — and free — resource is Credit Report Card (which gives you your credit score and breaks down the components of your credit report to show you where you’re doing well, and which areas of your credit you need to work on to build your credit). FHA loans and conventional loans are the meat and potatoes of today’s mortgage market. These product types represent the lion’s share of nearly all loan applications. So why are these so pricey? Simply put, because a lower credit score means higher risk, the lender will charge a lower-credit borrower more to insure the loan against default. Let’s look at how it works out.
FHA Loan Nuts & Bolts: An FHA loan has two forms of mortgage insurance (this is what insures the lender against your defaulting on the loan). One is an upfront mortgage insurance premium, or UFMIP, financed and amortized over the loan term, which is based on 175 basis points of the loan amount. An additional monthly mortgage insurance premium is also applied using 135 basis points of the loan amount. On a $400,000 home loan for example, that’s an extra $486 per month for the benefit of carrying a loan insured by the Federal Housing Administration.
Calculating the mortgage insurance payments:
UMFIP – $400,000 loan amount × .0175 (UMFIP) = $7,000 + $400,000 = $407,000 financed loan amount. This figure determines the principal and interest payment
Monthly Mortgage Insurance – $400,000 × .0135 ÷12 = $450. This monthly premium inflates the mortgage payment by the most.
Conventional Loan Nuts & Bolts: You might think that the conventional loan — the most sought after — is the lowest cost mortgage available, right? Wrong! If your credit score is below 700 and you’re comparing mortgage offerings, some lenders won’t tell you that your conventional home loan is going to get very pricey, very fast.
Unlike its FHA counterpart, there is no up-front mortgage insurance premium with conventional financing, just a monthly premium based on a varying range percentage of the loan amount sought. And higher risk (because of a lower credit score) equals higher cost. Two factors that influence the price, above and beyond anything else, are the loan-to-value ratio and, of course, your credit score.
Calculating the mortgage insurance payments in two scenarios (with a loan amount of $400,000, with different credit scores):
1. 740 credit score, with 5% down — mortgage insurance based on 76 basis points.
2. 640 credit score, with 5% down — mortgage insurance based on 120 basis points
Monthly mortgage insurance
$400,000 × .0076 ÷12 = $253.33 per month for 740 credit score
$400,000 × .0120 ÷12 = $400 per month for 640 credit score
Notice that it’s $147 per month more for the same loan with a lower credit score! By reducing the loan-to-value (by putting more money down, for example), a person with a lower credit score could receive a lower percentage of mortgage insurance on a conventional loan. However, even someone with a higher loan to value, and a higher credit score will typically secure a less pricey home loan. Generally, conventional loans are lower-cost compared to a loan insured by the FHA.
Consider the following when determining your mortgage options:
- What is my credit score? Can I improve it?
- What type of down payment do I have? (Note: Any home loan with less than 20% down will require monthly mortgage insurance, making the loan pricier.)
- Can I put more money down? In other words, buy less house, apply for less debt.
- Can I afford a higher monthly mortgage payment?
- Is my monthly income enough to meet all of my monthly debt payments and a proposed new mortgage payment?