For most people, mortgage loans are a bit of a mystery. It’s a somewhat complicated financial product that has a lot of moving pieces, and the average person is only going to get about a handful in their lifetime. However, buying a home is the largest investment most people will ever make so it’s essential that buyers know what they’re getting into.

Understanding credit scores and how they factor into a mortgage loan is crucial before beginning a home search. Why? Because real estate experts agree home buyers should get pre-approval before putting in an offer.

What is Loan Pre-Approval?

Loan pre-approval is the process of seeing how much a buyer qualifies for and what is factoring into a person’s ability to qualify for a loan. Without it a buyer can’t be sure how expensive of a home they can actually afford to buy. The last thing a buyer wants is to find the home of their dreams only to realize after putting in an offer that they can’t get a loan for the amount needed.

The pre-approval is not a formal approval for a loan. However, a lender will use similar financial tools and information to give a buyer a good estimate of what they would be approved for should they apply for a loan. The pre-approval letter will provide basic details and is accurate for up to six months.

This is why getting personal finances in order before searching for homes is so important. Many real estate agents and lenders suggest that home buyers carefully examine their financial situation and look for areas of improvement at least six months before the pre-approval.

Credit Scores and Interest Rates

The Federal Reserve has a lot to do with the current interest rates, but that’s just one piece of the home buying puzzle. The buyer’s credit score is going to significantly impact qualification, and it will most certainly be the determining factor for the interest rate on a loan.

The interest rate of a mortgage loan is what the lender charges the buyer in exchange for a lump sum of money. It makes the agreement lucrative and helps to minimize risk. A buyer’s credit score is an indicator of the risk involved with making a loan and how likely a person is to repay it. Thus, people with high credit scores are considered less of a risk and receive a lower interest rate.

Interest rates may seem low today, but just half a percentage point can add tens of thousands to the ultimate cost of owning a home. The more a person improves their credit score before applying for a loan, the less they will end up paying and the better their investment will be.

What Has the Biggest Impact a Credit Score

  • Late Payments – Brings a score down and stays on a person’s record for seven years.
  • History of Making Payments on Time – Brings the score up.
  • Debt-to-Credit Amount – Maxing out credit lines can lower a credit score. Keeping debt-to-credit low will help buyers avoid looking as if they are overextended.
  • Credit History – The longer a person has been using credit and effectively managing it the higher their score will be.
  • The Types of Credit Used – Lenders prefer that borrowers have a mix of credit lines. For example, a car loan, a few credit cards and a retail account.
  • New Credit Lines – Opening a few new lines of credit can temporarily lower a person’s credit score.

If a person’s credit score is low, financial experts recommend that they take time to fix some of the issues above. This will help ensure they get the best interest rate possible and increase their chances of qualifying.

Other Factors That Affect Loan Qualification

The buyer’s credit score is just one factor, but it can be the determining factor of whether or not a person qualifies for a loan at all. Other things that lenders take into consideration when determining the maximum loan amount and interest rate include:

The Buyer’s Assets – If a person has a significant amount of money and other assets that can be used to guarantee repayment this can have a positive impact. It makes the risk of default appear much lower.

Loan Term Length – There are a number of mortgage loans available. Loans with a shorter term length are going to have a higher monthly premium. Opting for a longer term length can increase a buyer’s chances of qualifying for a loan.

Size of the Down Payment – The higher the down payment is the better the loan terms will be. A sizeable down payment will also lower the overall cost by minimizing the size of the loan and possibly eliminating the monthly mortgage insurance payment.

Home Value – If the home is valued for more than the loan amount this is beneficial for the borrower.

Average Long-Term Interest Rate – The average long-term interest rate is a benchmark on which all interest rates are set. This will give a borrower a good idea of the interest rate they can expect based on their credit score. Despite predictions, the current average long-term interest rate has dropped, which is good news for buyers.

The U.S. and Global Economy – This is in relation to the point above. Average interest rates are affected by the U.S. and global economy. The Federal Reserve decided not to increase interest rates recently due to global economic pressures.