As mortgage rates tumble to multi-year lows, there’s been a massive surge in refinances and new mortgage applications. The drop in mortgage rates is one of the key reasons why I don’t think there will be a housing downturn as vicious as the one we saw between 2008 – 2010.
Further, it takes about six months for the effects of a large mortgage rate change to show up in the housing data.
If you want to get a better indication of what the future might look like, simply check out the performance of a homebuilding ETF like XHB. At the time of this publication, XHB is up ~26%, significantly outperforming the S&P 500 index YTD.
In addition to lower interest rates, higher lending standards post-financial crisis is another reason why the next recession shouldn’t be as bad as the last.
Gone are the days of negative amortizing liar loans to people with terrible credit. It has become far more difficult to get a mortgage today. Let’s look at some data.
The Average Credit Score To Qualify For A Mortgage
According to the latest quarterly report on household debt and credit by the New York Fed, 9 out of 10 U.S. mortgages go to borrowers with a score of 650 or better. Three quarters go to borrowers with scores of better than 700. Meanwhile, the average credit score for the 50th percentile is about 760.
Here is a graphical representation of the average credit score at origination.
Based on my experience refinancing multiple mortgages multiple times since 2003, having a credit score under 700 is not going to cut it. You now need a credit score of 760 or higher to qualify for the best rates on average. Even a 760 might not offer the best rate based on my current refinance where the loan officer started the application process asking if I had a credit score of over 800.
If you do end up qualifying for a mortgage with a less than a 760 credit score, your lender will likely be charging you 0.125% – 0.75% more than if you had had a 760+ credit score.
Stop thinking that a credit score above 670 is “good” according to FICO. It really isn’t, just like how it’s not good the average American has a median net worth of only about $87,000, has never traveled abroad, and will likely die younger than they are supposed to due to cardiovascular diseases.
Being average or median is not good when it comes to our finances. We are in a winner-take-all society.
Mortgage Originations By Credit Score
To highlight this winner-take-all reality, take a look at this mortgage originations by credit score chart by the NY Fed.
The light blue and dark grey sections indicate qualified borrowers with credit scores of 720+. They account for roughly 70% of all mortgages.
You need a minimum of 620 to qualify for a government-backed loan by Fannie Mae and Freddie Mac. However, the government, in all its wisdom, allows you to qualify for a Federal Housing Administration mortgage with a credit score as low as 500 if you can make a down payment of at least 10%.
When a downturn comes, borrowers who received government-backed loans will likely suffer the highest default rates.
Wait Until A Credit Score Of 720+ To Get A New Mortgage
Owning a home is not a right.
Pre-2008, too many people, who really couldn’t afford to, bought homes. While we can certainly blame lenders for lowering their credit standards and coming up with creative mortgages to entice unwary borrowers, we should also not shirk responsibility for our decisions.
The easy way to save homebuyers from potential loss and save the economy from potential catastrophe is to not take out a mortgage until you have a credit score of 720 or higher, instead of the current 620 or higher. This way, if things go south, default rates won’t increase as much as they would for borrowers with lower credit scores.
The idea is similar to not eating a cookie until you’ve run at least the number of miles it takes to burn off that cookie. If you don’t, you will eventually get out of shape. The idea is also similar to not buying a car until you make 10X its cost in annual salary. Although the 1/10th rule for car buying is pretty extreme, if you follow it, you’ll likely never experience car buying remorse.
Since 2012, the housing market has had a tremendous bull run. There should be no urgency to buy a home at near record-high prices without the best mortgage terms. Instead, I would work to improve your credit score to 720+ before applying for a mortgage.
The five main components that determine your credit score are: Payment History (35%), Amounts Owed (30%), Length Of Credit History (15%), New Credit (10%), and Types Of Credit Used (10%).
The weightings of each component are rough estimates that vary from person to person. For example, someone who just started taking out credit may have a lower percentage weighting in the Length Of Credit History component vs. someone who has used credit for over 30 years.
The main way to improve your credit score is to always pay your debt on time for as long as possible. Do not try and game the FICO scoring system. Keep things simple.
When it comes to taking on debt, stay disciplined.
Looking to take advantage of lower rates? Check out LendingTree, one of the largest online lending platforms today that will get lenders to compete for your business. They are listed on the NASDAQ and have a market capitalization of roughly $4 billion.