A Guide to Understanding Credit Scores, Their Impact, and Importance in the Mortgage Process

Credit can be a scary thing to discuss. The word “credit” can describe so much about your financial capabilities and outline your financial deficiencies. However, credit is not something you can escape if you wish to apply for a mortgage. The best thing to do when mortgage talks are beginning is to get familiar with your credit score.

In this guide, we aim to help you understand how credit scores work and how they can influence mortgage approval and terms.

What is a Credit Score?

Your credit score is the story of your past dealings with credit lenders. This can be credit cards, car loans, financial institutions, student loans, etc. Any institution that you have borrowed money from submits regular reports to the credit bureau, which creates a story of your credit history. If you thought your unpaid cell phone bill from five years ago was out of your life, think again. Credit bureaus receive information and keep a running record of all reported credit, good or bad.  Your credit score is generated from the compilation of submitted records, and your eligibility for a mortgage is assessed based on how well you score.

In Canada, the FICO credit scoring model is primarily used. Your score is calculated based on various factors, including payment history, credit utilization, length of credit history, types of credit accounts, and recent credit inquiries. The score ranges from 300 to 900, with higher scores indicating better “creditworthiness.”

The Basics of Credit Scoring

A credit score represents how likely someone is to repay borrowed money from an accredited institution, whether a Big Five bank or phone company. Lenders use credit scores to assess the risk of lending money to an individual. 

Here are some of the main factors that influence a credit score:

• Payment History: This is the record of whether or not you’ve paid your bills on time. Late payments and defaults can significantly lower your credit score.
• Credit History: This takes into account how long your credit accounts have been active. The length of the history can demonstrate an ability to manage credit over time, which can be seen as positive by lenders.
• New Credit Accounts: Opening multiple new credit accounts in a short period can be seen as risky and could negatively impact your credit score.
• Diversity of Credit Portfolio: Lenders generally like to see a mix of different types of credit, such as credit cards, installment loans, and mortgages.

How Credit Scores Affect Your Mortgage

Credit Scores and Mortgage Rates

Your credit score has a direct impact on the interest rates offered by lenders, which in turn affects the affordability of the loan. Lenders use credit scores as one of the key factors in determining the risk associated with lending money to a borrower. The higher the score, the lower the risk for lenders. Conversely, a lower credit score suggests higher risk, such as missed payments or loan default.

The difference in interest rates between borrowers with excellent credit scores and those with poor credit scores can be substantial. Even a small shift in these rates can significantly impact the total cost of borrowing over time, especially for long-term loans like mortgages.

For example, most mortgage products have minimum score requirements. Borrowers with credit scores of 650-900 can typically qualify for a mortgage through traditional lenders, while borrowers with scores below 650, and in some cases, 600, will likely need to look into alternative lending or a plan to increase their credit scores.

Loan Eligibility and Credit Scores

Credit scores play a crucial role in determining eligibility for various mortgage products, and they can significantly influence the terms and conditions offered by lenders. Here are a few ways that credit scores can affect the mortgage process:

• Eligibility: Borrowers with higher credit scores are more likely to qualify for a wider range of mortgage products, including those with more favourable terms and lower interest rates.
• Interest Rates: Borrowers with higher credit scores generally qualify for lower interest rates on their mortgages, while borrowers with lower credit scores may be offered higher interest rates to compensate for the increased risk they pose to lenders.
• Down Payment Requirements: Borrowers with lower credit scores may face stricter down payment requirements. Lenders may require these borrowers to make a larger down payment as a way to mitigate the risk associated with their lower credit scores.
• Mortgage Insurance: Mortgage insurance premiums are constant for high-ratio mortgages, but they do require a minimum qualifying credit score of 600.

Improving Your Credit Score for a Better Mortgage

Strategies for Improving Your Credit Score

If you do not have perfect credit, don’t worry; you are not alone. Many people need to work hard at improving their credit before buying a house. Here are some ways you can improve your credit:

• Don’t Max Out Credit Cards: Do not let your credit cards reach more than 75% of the maximum spending limit. Keeping them paid down to a lower percentage or paid off each month is the best option. Continuously maxing out your credit cards indicates that you may have a spending problem or not be responsible with your finances. In addition, credit utilization has a direct impact on scoring and is often the easiest way to quickly improve your credit score.
• Pay Off Outstanding Bills: If you have an old phone bill, for example, the cable company has already submitted your negligence of payment to the credit bureau. Pay the bill and contact the cable company directly to request they remove the negative comment from the credit bureau. The fewer negative points you have on your credit score, the better.
• Minimize Amount of Credit Cards: Do not apply for every credit card that offers you an incentive. Having access to too much credit is not seen as a good thing, especially if the credit cards are opened close together in time. A rush to apply for multiple credit cards could make it look like you are experiencing financial difficulties.

Monitoring and Maintaining a Healthy Credit Score

By staying proactive in monitoring your credit score, you can safeguard your financial well-being and make informed decisions about your credit management. Here are a few reasons monitoring your credit score is so important:

• Preventing Identity Theft: Monitoring your credit report allows you to detect suspicious activity or unauthorized accounts that may indicate identity theft. By reviewing your report regularly, you can catch fraudulent activity early and take steps to address it.
• Ensuring Accuracy: Errors on credit reports are not uncommon. By regularly checking your report, you can identify and dispute any inaccuracies.
• Maintaining Good Credit Habits: Monitoring your credit report can also serve as a reminder to maintain good credit habits over time. By keeping an eye on your financial accounts and credit activity, you can stay informed about your overall financial health and take proactive steps to improve or maintain your credit score.

Navigating the Mortgage Process with Your Credit Score

Preparing to Apply for a Mortgage

Preparing for a mortgage application requires careful planning. The goal is to present the best possible financial picture to lenders. Here are a few tips that will help you prepare:

• Check Your Credit Score: Start by checking your credit score well in advance of applying for a mortgage to find out where you stand.
• Improve Your Credit Score if Necessary: If your credit score is low, take steps to improve it before applying for a mortgage. Paying down debts, timely payments, and avoiding inquiries are a few ways that you can improve your score.
• Understand the Best Time to Apply: Timing is crucial when applying for a mortgage. Consider factors such as interest rates, housing market conditions, and your personal financial situation.
• Gather Financial Documentation: Lenders will require various financial documents as part of the mortgage application process. Gather documents such as proof of income, proof of assets, and information about any debts.
• Save for a Down Payment: The percentage required for a down payment may differ depending on the value of the home. Do some research into the market and set a comfortable savings goal. Also, explore options programs available through lenders or government-backed programs that support home buyers.

Professional Advice on How to Build Up Your Credit

Understanding credit scores is paramount when embarking on the journey of homeownership, particularly when it comes to securing a mortgage. Your credit score serves as a crucial factor in determining not only your eligibility for a mortgage but also the terms and interest rates you’ll be offered.

At The Mortgage Advisors, we specialize in guiding individuals through the complexities of the mortgage process, offering personalized advice tailored to your unique financial situation. Contact us today for expert insights and assistance in navigating the path to homeownership with confidence.