Conventional loans are crème de la crème of the mortgage market. This loan type offers the best possible terms and fees as well as relatively sustainable long-term affordability. However, those who come to the table with little equity and lower credit scores may find that a conventional loan costs them more than other alternatives. Here's how to know if you need to explore your options.
A conventional loan is a mortgage originated by banks, lenders and brokers across the country and sold on the primary mortgage market to Fannie Mae and Freddie Mac. This type of loan offers the best terms and rates due to its mass appeal and large-scale availability. However, this mortgage type also contains what's known in banking as risk-based pricing — a premium commensurate with the risk of the consumer's financial picture.
A Conventional Mortgage Scenario
With a conventional mortgage loan, a borrower's credit score is the biggest driver of cost.
If your credit score is between 620-679, you can expect to see higher costs when:
- You're refinancing to reduce your monthly payment.
- Your loan size is more than $417,000 (or whatever your county's conforming loan limit is).
- You have less than 20% in equity/down payment.
Other factors that affect the price and rate of a mortgage include: occupancy, property type, loan-to-value and loan program.
So let's say your homebuying scenario looks like this:
- Primary home
- Single family residence
- Conventional loan
- 5% down payment
- 630 credit score
- $417,000 loan size
Due to the lower credit score, it would not be uncommon to see an interest rate on this type of scenario approximately 0.375% higher than the average 30-year primary mortgage rate.
Also, when there is less than 20% equity or down payment (so 80% or more of the home price is being financed), the lender requires the borrower to pay a mortgage insurance premium of approximately 110% of the loan amount on an annualized basis. The borrower's credit score also factors into the mortgage insurance premium amount for a conventional loan — the lower your score, the more you'll pay in mortgage insurance.
For someone with a 630 credit score in this case, that might be $4,587 per year, which would be $382 per month in mortgage insurance.
However, with a 700 credit score, the interest rate could be 0.25% higher than the primary market rate and the mortgage insurance premium would be approximately $3,127 per year — or $260 per month.
This is why it pays to have a good credit score when applying for a conventional loan. So if you expect to buy a home in the next year, now is the time to check your credit scores and credit reports and get yourself on a plan to build your credit. A lender can give you guidance on the best steps to take, too. (You can get your free credit report summary on Credit.com, updated every month so you can track your progress.)
How to Reduce Your Mortgage Costs
Often, you can raise your credit score simply by paying down credit card debt (this calculator can show you how long it would take to pay off your credit card debt) – though of course it all depends on your individual credit history. Ask your mortgage professional if they offer a complimentary credit analysis with their credit provider. Most brokers and direct lenders offer this service. By having the mortgage company run this analysis, you can see how much more your credit score could increase by taking specific actions. Generally, a good rule of financial thumb is you keep your credit cards to no more than 30% of the credit limits per credit card.
You may also want to consider putting more money down when buying a home to help offset a lower credit score.
Or, you may want to change gears and go with a different mortgage loan program. An FHA loan could be another viable route in keeping monthly mortgage costs affordable.
A loan insured by the Federal Housing Administration (FHA) used to be considered the most expensive mortgage available. That dynamic changed in early 2015, when the FHA announced it was reducing its annual mortgage insurance premiums to a fixed 0.80 premium, regardless of loan size or credit score.
Comparing an FHA loan to our conventional mortgage loan scenario above, the FHA does not discriminate on credit score the way a conventional loan does and the mortgage insurance premium on FHA loans is constant. There is no sliding scale based upon credit score like there is on the conventional side. The FHA loan of $417,000 would generate a monthly PMI payment at $278 per month, a whopping $100 dollars per month lower than the conventional loan for the lower credit score.
Granted, an FHA loan does charge an upfront mortgage insurance premium of 1.75% usually financed in the loan, but the effect of the payment would only change by approximately $30 per month, meaning the FHA loan is really $308 month, making the FHA loan a lower cost monthly alternative for the lower credit score scenario.
Other FHA loan facts:
- FHA is not limited to first-time home buyers — it's open to everyone.
- FHA loans can be used to purchase a home or refinance a home.
If you are in the market for a mortgage and are trying to refinance or purchase a home, consider working with your loan officer to qualify on as many loan programs as possible upfront. Taking this approach can also allow you cherry-pick which loan is most suitable for you considering your payment, cash flow and home-equity objectives within your budget.
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