It’s one of those home-buying riddles that many think is all but unsolvable: How can a home buyer get a mortgage with bad credit? After all, if your credit score is abysmal, you may as well kiss your dreams of a home loan goodbye. Right?
Wrong. In spite of what you’ve heard, there is hope for home buyers or people who want to refinance their home loans, but who have less than perfect credit—or even bad credit.
By “bad credit,” of course, we mean your credit score—that all-important numerical representation of your track record of paying off past debts to lenders, covering everything from your credit card to college loans. Mortgage lenders check your credit score to gauge how good you’ll be at paying them back, too, and a low credit score can definitely work against you.
According to a national survey by Experian, one-third of prospective home buyers are afraid that their poor credit score will reduce their chances of purchasing a home. Meanwhile, 45% of people polled in the subprime market say they’ve decided to delay home buying until their credit score improves, with 1 in 5 believing that their bad credit means they’ll have to shelve the idea for at least five years.
Is this true? Exactly how bad is subprime credit, anyway? We’ll set you straight below, and offer some guidance on how to get a mortgage when you want to buy a house or refinance, but your credit report shows you have poor credit.
How to check your credit score
Before you can explore your loan options with possibly bad credit, you need to assess what shape your credit is really in, says Todd Sheinin, a mortgage lender and chief operating officer at New America Financial in Gaithersburg, MD. For starters, credit scores range from 300 to 850, and are calculated based on the following factors:
- Payment history: 35%
- Debts owed: 30%
- Length of credit history: 15%
- Types of credit you have: 10%
- Applications for credit: 10%
By law, you’re entitled to a free copy of your credit report once a year from each of the three major credit bureaus: Equifax, Experian, and TransUnion.
You can request the reports through AnnualCreditReport.com. However, your credit report only shows your credit history; to see your actual score, you’ll need to pay a small fee directly through the credit bureaus’ websites. (Alternatively, you can get a free estimate of your score through Credit.com, CreditKarma, or CreditSesame. Some credit unions and other financial institutions also let you see your credit score.)
If your credit score is 760 or above, you’re considered a low-risk borrower—meaning that lenders are likely to offer you the best interest rates and terms when you apply for a loan. Meanwhile, a good score is from 700 to 759, a fair score is from 650 to 699, and credit scores below 650 are seen by lenders as poor credit scores, sometimes referred to as sub-prime.
If your low credit score is below 650, you may want to step back and take a few months to raise your score before you apply for a mortgage loan. You might be surprised how much your FICO score improves with several months of on-time payments and other strategic improvements to your credit report. If your credit report is just thin, with not enough history of making monthly payments, you might consider getting a credit card to improve your creditworthiness. (A credit card only improves your credit score if you keep it in good standing, so do your best to avoid late payments.) Another option if you have subprime credit is to get a co-signer. But if you’re looking to buy a home right away and your credit report shows that you have bad credit, you do have options for a bad-credit mortgage.
Option 1: FHA loan
If you have bad credit, you might still be able to qualify for a government-backed Federal Housing Administration (FHA) loan. Because FHA loans were created for low- and moderate-income borrowers that would otherwise be locked out of the housing market due to bad credit scores, qualifying credit scores on FHA loan programs start at minimum credit scores of 580 and up. Another bonus: FHA loans let borrowers, regardless of credit history, make a down payment as low as 3.5%.
The downside? Because FHA loans are government-insured, FHA borrowers must pay an upfront mortgage insurance premium. Currently the loan program fee is 1.75%—that’s $5,250 on a $300,000 home loan. FHA borrowers also have to pay annual mortgage insurance, currently around 0.85% of the borrowed loan amount—or $2,550 more per year. All those fees increase your mortgage payment every month. Also, FHA loans are usually capped at $417,000. (In certain high-cost areas, the FHA mortgage loan limit is $625,000.)
Option 2: VA loan
Active and retired military are eligible for a loan offered by private lenders through the U.S. Department of Veterans Affairs. Not only do lenders working with the VA accept credit scores of 620 and below, but these lenders require no down payment and no mortgage insurance premium—all at decent interest rates.
“Because interest rates are fixed on VA loans, they’re not based on the borrower’s credit score,” Miller says. In other words, because the government guarantees a portion of the loan, having bad credit and no down payment won’t prevent lenders from offering you a great mortgage loan rate.
Option 3: 15-year fixed-rate loan
Good news: Most conventional loans only require a minimum credit score of 620, based on Fannie Mae and Freddie Mac guidelines. However, “if you have a 620 credit score, you’re going to pay a higher interest rate,” says Heather McRae, a senior loan officer at Chicago Financial Services. But there is one interesting exception.
“If you get a 15-year fixed loan, the lender will essentially turn a blind eye toward your low credit score with respect to what interest rate you get,” says McRae. In other words, for a 15-year fixed loan, a lender would offer the same interest rate whether the borrower has a 620 or a 750 credit score.
You can also look at a 15-year adjustable-rate loan. Sometimes lenders offer lower initial rates on adjustable-rate loans, meaning that you are more likely to qualify for the monthly payments.
Granted, lenders will still require that you meet other requirements in terms of income, down payment, debt-to-income ratio, and other factors. For a refinance, with or without a cash-out deal, you must meet loan-to-value requirements. Lenders want to see a solid salary and plenty of cash upfront to get a purchase or refinance home loan with bad credit. Still, it’s a great option if your past bad credit issues are haunting you, while your present circumstances are solid and scream “All systems go!”
Option 4: A bigger down payment for a bad-credit mortgage
Some mortgage lenders might be willing to approve you for a home loan, even with bad credit, if you make a larger-than-usual down payment. Why? Because lending is a risk-based business, and a borrower who makes a larger down payment is less likely to default. “The more you put down, the more you minimize the risk to the lender,” says Sheinin.
So, by increasing your down payment to 25% or 30% on a conventional loan—instead of the standard 20% down payment—you’ll strengthen your mortgage application. You should also show the lender a strong debt-to-income ratio and steady income history. Bear in mind a bad credit score can still negatively affect the loan interest rate offered by your lender.
Whether you expect to apply for an FHA or VA loan, or other type of loan, consider talking to a mortgage broker before you go house shopping and get pre-qualified for a loan. This is especially important if you are a first-time home buyer, because a mortgage broker can help you avoid looking at houses you can’t afford, or talk to you about what you need to do to qualify for the house you have your heart set on.
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