Buying a home is likely the biggest investment for many. Getting a loan can be a stressful experience. And co-signing for a loan can be a big decision. Before signing on the dotted line, what credit score do you need to co-sign a loan?
Things are a bit more complicated when it comes to mortgage loans now than it was when I first was a mortgage banker back in the mid-1980s. While the basic rules are the same about cash reserves, down payments, debt-to-income ratios, and credit, the credit score is so much more important.
Lenders now use “risk-based pricing” to determine the interest rate and cost (like points) that you’ll pay. This risk-based pricing is based on the credit score. Lenders will typically pull a credit report on each borrower from each of the three major credit bureaus. For underwriting they will use the middle credit score of the borrower with the lowest overall scores.
Credit scores are like SATs. You get a couple of hundred points just for having a credit file. The maximum score differs between the three bureaus but generally it’s somewhere between 820 and 850.
If your credit score is above 720, you’ll get the preferred (lowest) interest rates and costs (possibly zero points). As a borrower’s credit score goes down, the cost of the loan goes up as lender’s “add-on” to the rate and/or points to cover the “risk” that the borrower may default.
Credit scores are most impacted by how old the credit reference, how much you have outstanding compared to the maximum loan or credit line for that lender, the payment history over the most recent two years, and the number of recent credit inquiries.
First, I suggest finding out what your credit report looks like and what the credit score is. You are eligible for one free credit report from each credit bureau once per year. You can request these online or by writing to the bureaus. You can start here at this website sponsored by the federal government: www.annualcreditreport.com .
You can get an idea of what kind of credit scores you have by registering for free with CreditKarma (www.creditkarma.com). These won’t be the same as the ones used by lenders but it will give you a good idea.
To mitigate the impact of a co-signed loan for a car for instance, you may want to document that the primary borrower has paid the loan on time for at least one year. Most underwriters will consider not counting this as our debt as long as the payment history of the primary borrower has been documented.
Since it takes time for the credit report to reflect that the credit card balance has been paid off, you’ll likely still see an underwriter count a portion (3% to 5%) of the balance showing on the report as a monthly debt payment. Of course, you can pay it off and then wait to apply in four or 5 weeks and the credit report may be updated.
Assuming you do buy the home, remember that what the lender wants and what you need for your personal financial plan to succeed are two different things. The lender just wants to make sure that you can pay the mortgage. They don’t care if you have to eat ramen noodles. They don’t really take into account that you may have to fix a broken water heater.
So, you really should consider keeping or building a cash reserve equal to about 1% to 2% of the property value to cover such unexpected costs. More broadly, you should also consider targeting for at least three (3) months of cash that equal your fixed overhead expenses (mortgage, taxes, condo fee, insurance, utilities, student loans, car loans).
While a lender may have a maximum debt-to-income ratio of about 36% (housing expenses plus fixed loan payments plus credit card payments divided by gross income), I recommend that you adopt a 20/30/50 cash flow budget.
This means that you pay yourself first 20% of your after-tax take-home pay. This would go toward your savings, funding your retirement account, and prepaying any fixed loans or credit cards. Thirty percent should be the target for discretionary “wish” items like vacations, dining out, entertainment and similar items. The last piece (50% of net) should be what covers all the fixed overhead from mortgage payments to property taxes and other loans.
Finally, you’ll want to be sure that you have some basic life insurance coverage in place between what you get through your employer and directly on your own. You should both consider getting term policies and/or increasing group term coverage through your employers to cover the mortgage balance. Group term will be the cheapest and easiest to get but you lose it when you change jobs. This is why I prefer that clients get their own.
If you’d like an objective second opinion about your finances and are looking for a road map on how to live better by planning well, please reach out to Steve Stanganelli, CFP®, CRPC®, AEP® at Clear View Wealth Advisors, LLC. Email him at Steve@ClearViewWealthAdvisors.com.
