Getting a mortgage is no easy task. Folks looking to become homeowners tend to see obtaining a mortgage as the biggest hurdle in the entire home purchase process. While it’s extremely common for homeowners to get a loan to purchase their home, most home loans have strict eligibility requirements and hefty down payments.
Even if a down payment is the least of a home buyer’s concerns, every home loan product has eligibility criteria that must be met in order to qualify. Most of the criteria involves a borrower’s financial situation, with the most important part usually being their credit score.
Credit scores are easily one of the most sensitive topics for the average home buyer. This is partially because having a great credit score is actually pretty uncommon. Those of us who don’t have perfect credit and want to apply for home financing generally have to keep our fingers crossed that our credit score will meet the lender’s expectations.
To make matters worse, it can be incredibly difficult to repair your credit score. In fact, it could take months, even years, to repair a mediocre or bad credit score. For potential borrowers with credit scores that just don’t make the cut, buying a home can sometimes feel like a lost cause.
While it may seem as though hope is lost, and that renting is the only option, there are a couple ways to get a mortgage and buy a home even if your credit score is a little on the weak side of the spectrum. Now, before getting your hopes up, it’s important to remember that there really is no substitute for a good credit score. There are, however, ways to work with what you’ve got.
These are in no way an easy way out, either. Getting a home loan with less than perfect credit usually involves compromise in another aspect of the loan and additional burdens on the borrower. In some cases, the ideal solution is still to fix your credit before applying for a mortgage.
As a potential borrower and home buyer, it’s up to you to decide what steps to take in order to become a homeowner. Before getting into any options for buying a home with bad credit, it’s crucial to understand exactly what credit scores are, and how they function.
What is a Credit Score?
For such an important number to the common consumer, not many people are familiar with what a credit score truly is and how it works. Even more shockingly, there are quite a large number of people who are completely unaware of what their credit score is, and have never bothered to check. While the idea of credit scores is still relatively new, they have become such an important part of finance that every person should have at least an estimate of their credit score when looking to borrow money or finance a purchase.
Your credit score, for those still unsure of what it is, is a three digit number that acts as a numerical representation of a person’s ability to repay a debt. Lenders and banks often use credit scores as a means of determining the risk of lending money to a potential borrower. The lower the credit score, the higher the risk for the lender, and thus the less likely that the borrower is to be approved for a loan.
Credit scores, despite what they sound like, are not randomly assigned by some all-knowing finance elf. Instead, they’re determined through the efforts of the three largest credit bureaus in the country, using complex formulas such as FICO and VantageScore. Scores are calculated utilizing important financial factors such as a borrower’s payment history, credit tenure, amount of open credit lines, debts, and other factors.
Depending on the formula used (FICO, VantageScore, or a proprietary method) it is possible, (and quite common) to have different credit scores depending on where you look. Still, the most widely accepted score in finance, utilized by around 90% of financial institutions in the country, happens to be the FICO credit score. Either way, the information is more or less gleaned from the same material found in a credit report.
Credit scores typically fall within a set range from 300 to 850. Scores on the lower end are typically regarded as a higher risk, while scores on the higher end are considered lower risk. As such, it’s a common practice for lenders and loan guidelines to specify a minimum credit score that a borrower must have in order to qualify for a loan. Mortgage loans are typically very strict when it comes to credit score criteria.
How are Credit Scores Ranked?
As we discussed previously, credit scores can fall anywhere between 300 and 850. The higher the number, the better the score is and vice versa. There are even categories to help consumers get a better idea of where they stand on the spectrum.
The categories usually display credit scores as either bad, poor, fair, average, or great. Still, there is plenty to take in, as the bad credit category includes everything between a score of 500 and 579. This is an important thing to keep in mind, since credit scores can be as little as 300.
Effectively, this means that scores under 500 are generally too low to be accepted anywhere.
How to Increase your Credit Score
There are many ways that a borrower can increase their credit score. Sadly, many of them take time, and a good portion of them require money out of pocket. Still, for someone looking to give their credit a nice little boost, there are a few tricks that might help.
For starters, paying down any open credit lines or paying off any remaining balances is one of the fastest ways to gain a few points. Around 30% of the FICO credit score algorithm is based on a borrower’s credit utilization ratio. In case you were wondering, the credit utilization ratio is the percentage of credit that a borrower has used in relation to the total amount of credit available to them.
A good rule of thumb is that the higher the balances on any open credit lines, the lower your credit score will be. Paying those balances down is a great way to prepare for applying for a mortgage!
Another easy way to get a better score is to tackle any debts that have gone into collections. Debts that have made it to the collection phase are pretty big blemishes on a credit report. Simply paying these will definitely put a borrower on the right track, but there is a trick to it if you actually want to improve your credit score.
As it turns out, not only can these debts be paid off, but some agencies have a “pay to delete” option. Basically, a borrower can request a pay-to-delete agreement with the collection agency, which stipulates that the borrower will pay the amount in full in exchange for the account being permanently removed from their credit report. If an agency cannot agree to these terms, then paying off the debt will not affect your credit score at all, and might as well be left as-is unless specifically told otherwise by a lender.
One last awesome trick for a quick credit score boost is to become an authorized user on someone else’s credit account. Whether or not you actually have access to this person’s credit isn’t important, but by simply having your finances linked with someone in better credit standing than yourself can greatly improve how credit bureaus view your financial situation.
FICO scores incorporate that person’s entire credit history into the calculation of your personal credit score. This can easily net a credit increase of up to 30 points depending on their credit report.
Credit Scores for Home Loans
In the world of home finance, credit holds quite a bit of power. Everything from the type of loan you’re eligible to receive to the interest rate on the loan that you ultimately receive depends on your credit score. It is usually the first thing a mortgage lender looks at when a potential borrower applies for a loan.
As a matter of fact, a mortgage loan officer can’t truly know what options are available for a borrower without first knowing where their credit stands. Credit score requirements are written into basically every mortgage loan product on the market today. Even programs hailed for their less-strict eligibility requirements such as FHA loans have credit score requirements that must be met.
Even after a loan has been decided on and qualified for, a borrower’s credit score is a large factor in helping to determine the terms of that loan. Mortgage interest rates, for example, are highly dependent on a borrower’s credit. The higher the credit score, the lower the interest rate that a lender is willing to give.
To be eligible for most home loans, borrowers are expected to have a credit score of at least 620. This falls within the “fair” credit category, and the lower the score, the more interest a borrower is expected to pay. Many mortgage lenders, especially when it comes to conventional loans, require borrowers to have credit scores in the mid-700’s to be eligible for the best interest rates possible.
Borrowers with a credit score below the 620 mark will have a difficult time finding a lender who will approve a mortgage loan for them. That being said, financing a home purchase with a credit score below 620 is possible, but even the Consumer Finance Protection Bureau (CFPB) warns against many of these loans. According to them, the interest rates are so much higher than the market rates, they could cause a borrower to default.
A good credit score is an unbelievably powerful bargaining chip in a mortgage transaction. It almost makes it seem as though those with bad credit shouldn’t even bother trying to get a mortgage in the first place. It can be very discouraging, but in some cases, this is just a simple truth.
Sometimes getting a mortgage with bad credit just isn’t a financially feasible decision. Often times, it’s better to just wait it out until after your credit is repaired. Even so, buying a home isn’t always a lost cause for people with bad credit.
How Credit Scores Affect Mortgage Interest Rates
Besides basically dictating which loans a borrower can qualify for, credit scores play a large role in determining a borrower’s interest rate. The interest rate of a loan is a percentage that represents the cost to borrow a sum of money. Generally, the better a borrower's credit score, the lower the interest rate on the loan.
For a better representation of how credit scores affect the interest rate on a home loan, we’ve broken it down into a few credit score groups and the interest rates usually (but not always) associated with them:
740 or Higher = The best interest rates available
680 - 739 = The average home buyer typically falls into this category. This is where the standard interest rates are applied
620 - 679 = At this stage, there will be a slightly noticeable increase in a borrower’s interest rate, typically by around .5%.
580 - 619 = Borrowers in this category can expect to see an increase of around 1% from the standard rate.
500 - 579 = Borrowers with credit in this tier might see interest rates with an increase of up to 2% from the standard rate. Any credit score under this tier is subject to subprime mortgages with much higher interest rates.
Now that you have a decent idea of how important credit scores are to the mortgage industry, we can finally take a look at home loan options for people with bad credit.
Home Loans for People with Bad Credit
As a general rule, it’s a tough task to find a home loan with a credit score under 620. Most lenders, even if loan guidelines allow for lower credit scores, simply will not be willing to enter a mortgage transaction with a borrower whose score is below 620. Luckily, most isn’t all, and there are definitely some exceptions to this norm.
So, if you’re a borrower with a credit score below 620, here are a few options available in order to purchase a home:
It should be no surprise that mortgages insured by the Federal Housing Administration would make the absolute top of the list. FHA loans have awesomely flexible eligibility requirements and super-low down payment requirements. That’s why are the most highly recommended choice when it comes to home buyers with less than perfect credit, particularly first time home buyers.
According to the guidelines set by the Federal Housing Administration, credit scores as low as 580 are acceptable in order to qualify for an FHA loan with only a 3.5% down payment. That isn’t even the best part. The FHA is also willing to approve borrowers with scores between 500 and 579, providing they are able to make a minimum 10% down payment.
FHA Loans are much easier to obtain for home buyers who are just short of the 620 credit score that most conventional loans require. Add that to the much more affordable down payment options, and it isn’t hard to fathom that FHA loans are the perfect option for a home buyer with bad credit.
On the conventional side of things, subprime mortgages might be the only other available option. As the name implies, subprime mortgages are well below the prime rates. This means that, in exchange for having bad credit, borrowers are expected to pay more and meet stricter requirements in other areas.
Subprime loans usually allow borrowers to have credit scores as low as 500, just like their FHA counterparts. Sadly, subprime loans have significantly higher interest rates than FHA loans. In general, it’s best to avoid subprime mortgages at all costs, since they can be incredibly risky for the borrower, as well as the lender. Many subprime mortgage packages are sold as adjustable rate mortgages, which may seem to have affordable rates at first, but can quickly get out of hand with each rate adjustment.
As if that weren’t bad enough, some subprime loan offerings have negative amortization. This lowers the monthly payments by not covering the total amount of interest that should be paid each month. This leaves a large sum of money due at the end of the loan term, known as a balloon payment, which is expected to be paid in full.
How to Find a Home Loan with Bad Credit
Shopping around for a mortgage is always the best way to ensure that you are getting the best possible home loan for your financial situation. For home buyers with bad credit, this is doubly true. Since many lenders have strict credit requirements, home buyers with bad credit must search extra hard to find a lender who can work with their credit score.
When searching for a home loan with bad credit, it may be beneficial to skip over the big mortgage lenders and nationally acclaimed banks, and instead try speaking with some local lenders. While some of the national banks may still be able to provide a moderately affordable home loan to a borrower with bad credit, often times the lesser known companies are more willing to work with low credit borrowers. Borrowers should look into their local credit unions, mortgage companies, and community banks as a start.
For a little extra cost up front, utilizing a mortgage broker could save a home buyer plenty of time in finding a lender and mortgage product that they can qualify for, given their credit situation. Sadly, brokers are not obligated to find you the best deal available unless they have been specifically contracted by a home buyer to do so. In addition, mortgage brokers can easily be confused with mortgage lenders, so great diligence must be taken by a borrower looking to work with a broker to be sure that the contract is transparent and will be to the borrower’s benefit.
For home buyers interested in the FHA loan option, the HUD website has you covered. Borrowers can use the Federal Housing Administration’s lender lookup tool to find certified FHA lenders in the area of the borrower’s choosing. With a list of approved lenders, it should be much easier to find lenders who can provide mortgage solutions for home buyers with bad credit.
How to Increase your Chances of Getting a Mortgage with Bad Credit
Home buyers plagued with bad credit have a much better chance of being approved for a loan if they have a little more to offer in other areas. A few good tips for borrowers with bad credit include:
Making a larger down payment - Lenders typically view borrowers who can provide a substantial down payment as lower risk.
Cosign on the Mortgage - Getting someone to cosign on the home loan may greatly increase the chances of not only being approved for a mortgage but actually getting reasonable rates as well.
Try to raise your credit first - Fixing credit can take a long time, but the reward generally outweighs the effort in the long run. Better credit means greater mortgage opportunities with less risk.
When is it Worth it to get a Mortgage with Bad Credit?
A truly important thing to remember is that just because a borrower is approved for a home loan, that doesn’t mean that it’s always a good choice to make. Getting a mortgage with bad credit can mean being charged ridiculously high interest rates and having extra closing costs to contend with. At the end of the day, a subprime mortgage may be more of a risk to the borrower and could even lead to them defaulting in the future.
For borrowers who still wish to move forward with finding a home loan despite bad credit, here are a few things worth considering before signing any contracts:
Getting a loan with an incredibly high interest rate basically equates to paying more for the loan than if you waited to repair your credit.
It is HIGHLY recommended that mortgage payments never exceed 30% of your total monthly income. If the loan that you qualify for requires larger monthly payments that exceed that amount, then you could run the risk of not being able to afford your home and the even greater threat of foreclosure.
Borrowers whose credit scores are impacted by unresolved debts should take care not to add another large debt to their plate before they are truly able to afford it.