There are many things to consider when buying a home, including how to snag the best mortgage rate. A big part of getting a good rate requires building a solid credit score. Credit scores are intricately linked to credit card use, and the rules aren't always be intuitive. By spending responsibly and following proven credit-building techniques, you can work your way to lower mortgage rates. People are often confused about how closing credit cards affects their credit score. Here, we'll explain the effect closing an account has on your shot at a good mortgage rate.
How credit score impacts mortgages
How your credit score affects your mortgage rate is simple. The higher your score, the lower your rate. The lower your score, the higher your rate. If your score is too low, you could be rejected for a mortgage entirely. Your credit score tells lenders how much they can trust you to pay your loans on time. If you have a history of missed payments and high credit utilization ratios, lenders will be wary of loaning you money.
The impact your credit score has on your mortgage is huge. Say a Californian with a 775 credit score applying for a 30-year fixed loan can expect to pay an APR of 3.783%. A person with a 630 credit score applying for the same loan will pay a 5.372% APR. To get an idea of what kind of mortgage rate you can expect for your credit score, you can use the myFICO.com loan calculator. It breaks down interest rates by loan type, credit score, state of residence and principal amount (how much you're actually borrowing).
If your mortgage is just 1-2% higher, that can mean hundreds of thousands of dollars in interest after a couple of decades. In the example above, the difference in interest paid comes out to $34,126--over a third of the principal amount. If you can wait a couple of years to buy your home while you build your score, it could save you a lot of money in the long run.
Why closing a credit card is bad for your FICO score
In many instances, closing a credit card will hurt your credit score. That's because part of your credit score depends on your credit utilization ratio, which is the percentage of your available credit you are currently using. So it helps to keep a high credit limit (with minimal debts, of course). Experts recommend staying under 30% of your overall credit limit.
Keeping your credit limit high means keeping your accounts open. Let's look at a quick example. If you have 3 credit cards, each with a $5,000 limit, closing a single card will lower your limit by a third. If you have $5,000 in credit card debt, your credit utilization jumps from 33% to 50%. That's not good for your credit score.
There are a couple of situations when closing an account might help your credit score. That might happen when you have too many lines of credit (over 5 credit cards starts to look bad) or if you're closing a store credit card (lenders don't like to see these). Otherwise, keep your accounts open for as long as possible. Sometimes that can mean paying an annual fee, but it could be well worth the lower mortgage rate.