We have all been there before. Maybe you borrowed more than you could repay or you missed a few too many payments on your credit card. Before we purchased our first house, we knew we had missed a credit card payment on more than one occasion due to simple forgetfulness. We were afraid we wouldn’t qualify for the loan we wanted because of our low credit score. After doing our research, we still decided to go for it — and we’re glad we did!
The good news is that you can still purchase a home with bad credit. The bad news is that you will have a more difficult time doing so, and it may even be more expensive. If you think that you are ready to take that next step and get into a home, here is the breakdown of everything you need to know first.
Find Out What Your Credit Score Is
Before you can even determine if you are eligible for a loan, you need to know what kind of credit score you are working with. Many banks or credit card companies will provide you with your score as a complimentary service. You might find it listed on an old statement or through the online portal of your checking or savings account. I recently discovered that my credit card offers this service on each of my monthly statements, making it much easier for me to keep track of where my financial health is.
If your bank doesn’t provide you with access to your credit score, then consider enrolling in myFICO.com. For a small sum, you can gain access to your FICO credit score which is what most lenders will use when determining your loan eligibility.
Another important thing to do is to request your credit report. You can request your credit report for free once each year through any of the three major credit reporting agencies. This allows you to see all of the factors that influence your credit score. Do you see something on there that doesn’t add up?
There is always the possibility that there are errors on your credit report that can be corrected, giving your credit score a small boost. In order to do this, you’ll need to reach out to the bureau directly and prove to them that some of the info listed on your report may be incorrect. This process can take time, so if you’re in a crunch to buy a house, you may need to delay things while the credit bureau looks into your case.
When my parents were in the process of purchasing their new home, they found that their credit report wasn’t quite accurate. It still showed that they owed money on a couple of car loans. They wrote to the credit agency, provided proof that it had been paid in full, and were able to boost their credit score enough to qualify for their loan. It took them some time to get everything sorted out, but it was worth it to them in the end.
Higher Interest Rates Are Likely
The bank charges interest rates on every mortgage, but those with excellent credit scores typically pay less. Your credit score is an indicator of your overall likelihood of paying back your loan on time. If you have a poor credit score, lenders are likely to view you as more of a risk. As such, they protect their interests by charging you a higher interest rate and making more money from you in the long run.
A lender might offer someone with a good credit score a rate that is two points lower than someone with a poor credit score. This can sound minimal but you must consider how quickly this figure can add up.
Over the course of thirty years, this compounded interest can cost you thousands of dollars. Consider it this way: let’s say you want to purchase a house worth $200,000. You put down 20 percent, leaving you with a mortgage of $160,000. If you have a bad credit score, you might still have a high interest rate. And while it may not sound like a lot, the difference between a 4% and 3% interest rate could mean that you pay an extra $30,000 over the lifetime of your loan.
The good news is that you can get a loan now with a high interest rate and refinance it in the future. As you work on faithfully paying down your debt and boosting your credit score with consistent monthly payments, your financial risk becomes lower. You should never stop monitoring your credit score. Once it improves significantly, consider refinancing your loan to get more favorable terms and lower interest rates.
You May Need to Pay Down Debt
Even if you can find a lender who is willing to overlook your credit score, you will be hard-pressed to find one that will overlook your debt. Your debt-to-income ratio is a key indicator of whether you can afford to make a major purchase like a home. Ideally, lenders want to see a ratio of 36 percent or less.
Any more than this and your lender may not feel comfortable giving you a loan, because your debt is way too close to what you actually make. If you have a bad credit score, then you may want to make this number as low as possible.
What gets factored into your debt-to-income ratio? Consider all of the debts that you pay on a monthly basis:
- Auto loans
- Credit card debt
- Personal loans
- Student loans
- Child support
Tally up everything you spend on these types of expenses and then divide by your gross monthly income. Multiply that number by 100 and you have your debt-to-income ratio. For example, let’s say that you spend $300 on your car payment and have $400 in credit card debt. Each month, you have a gross monthly income (your income before taxes) of $2,000. This would give you a debt-to-income ratio of 35 percent.
When we were applying to purchase a home, we wanted to finance slightly more than what our budget could afford. We looked at our debt-to-income ratio and decided to pay off our car before making a purchase. This gave us a lower debt-to-income ratio, made us more favorable candidates for a loan, and allowed us to purchase a larger home. It was a winning situation all the way around!
Shop for the Best Deal
When you are in the market for a new loan, it can be tempting to sign up with the first lender who offers you a deal. Don’t fall for this common trap. Take the time to research multiple lenders and see who offers you the best deal.
When you apply for a new mortgage, the lender is going to get your permission to do a hard credit pull. This allows them to see the maximum information about your financial history including debts and repayment history. Unfortunately, a hard credit pull can dock your credit score by a few points.
Luckily, there is some wiggle room with this when it comes to shopping for loans. The credit bureaus typically allow you to shop for a new loan for fourteen days, and multiple credit inquiries will only be counted as one.
This is a crucial step that you don’t want to miss. When we applied for our first mortgage, we thought that going with our regular bank would be the best way to go. After all, they already knew us and our history. However, we were pleasantly surprised to learn that online lenders could offer us a better deal. It’s always a good idea to check around. Not to mention, one lender may deny you based on your credit score while another will take a second look. The more lenders you talk with, the better your chances are of being approved by someone.
What Kind of Loan Do You Qualify For?
Now that you know what you might be in for with a home loan for bad credit, it’s important to see what options are on the table. Here are the three most popular loan types you might want to consider to get you started on your path to being a homeowner.
For many people, an FHA loan grants them the freedom to begin considering the purchase of a new home. These loans can be advantageous because they offer a lower down payment. If you have a credit score of 580 or above, you can purchase a home with just 3.5 percent down. For those with a credit score that is between 500 and 579, you can still use this loan but will need a ten percent down payment.
Keep in mind that while these loans can absolutely be beneficial, they also have their disadvantages. There are more costs associated with an FHA loan compared to a conventional loan. First, you will pay an upfront mortgage insurance premium that must be paid at closing or added onto the total balance of the loan. It equals 1.75 percent of your loan amount.
In addition to that, you will also pay monthly mortgage insurance premiums that total 0.45 percent to 1.05 percent of your base loan amount each year.
Think about how quickly these numbers can add up and what they will cost you on a monthly basis. My husband and I were in the process of purchasing a new home and were considering using an FHA loan. This would have allowed us to keep more money in the bank instead of opting for a conventional loan with a twenty percent down payment.
However, the mortgage insurance premiums added almost $200 to our monthly payments. This wasn’t something that we could afford moving forward. That also meant that we would be paying almost $72,000 in mortgage insurance premiums over the lifetime of our loan.
Not to mention, those payments have no real benefit to the homeowner. They are designed to help protect the lender in the event that you default on the loan. It is money wasted each month that could go to more productive things like paying down your loan amount or making wise investments.
If you are an active or retired service member or a surviving spouse, then you may qualify for a VA loan. This is one of the best financial options for someone who has bad credit. The good news here is that there are no minimum credit score requirements set for this type of loan. Instead, lenders are going to look at your entire financial history before deciding. They will look at things like:
- Income amount
- Stability of income
- Debt-to-income ratio
- Financial history like making payments on time
Keep in mind that each lender will make their own determination. Even if the first lender you try rejects your application, it is worth trying several others before admitting defeat.
The VA loan is a particularly appealing option because you can finance 100 percent of the purchase price of the home. This means that you do not need to save up for a large down payment. It also typically has lower interest rates and does not require private mortgage insurance. However, just know that if you do finance 100 percent of the purchase price, you will have less equity in the home.
Equity is the difference between what you own on your house and what the house is worth. As you pay down the mortgage with monthly payments, the equity in your home increases. This might be important if you are planning on taking out a home equity line of credit or a cash-out refinance in the future. You will have to spend more time making payments in order to build up the equity for these scenarios.
Much like VA loans, USDA loans do not have a minimum credit score. Lenders are required to look at your entire loan profile before making a decision. These loans are designed for low to moderate income earners who may not be able to make a down payment. You can finance up to 100 percent of the property value. As an added bonus, PMI is not required on these types of loans either.
However, there are some limitations to the types of properties that you can purchase with this type of loan. They must be located in eligible rural areas per the USDA.
Building Up Your Credit
There is good news on the horizon. If you can find a lender who is willing to work with your low credit score, you can purchase a home and work on rebuilding your credit simultaneously. One of the biggest influencing factors for your credit score is your ability to make timely payments. Your mortgage company will report your payment history to the major credit bureaus. Over time, this simple act of paying your mortgage each month will improve your credit score.
This was the case for us when we purchased our first home. We went from having no credit at all to having just good credit a couple years later before purchasing our home. After the purchase of our first house and five years later, we now have excellent credit. This qualified us for better interest rates and terms on our next mortgage.
Even if you aren’t looking to sell your home and purchase a new one like we did, you can still refinance your existing home. This could give you a lower interest rate that can help you to save thousands over the next thirty years.
Purchasing a Home with Bad Credit Is Possible
Don’t let anyone tell you that it’s impossible to purchase a home with bad credit. Certainly, there will be a few pitfalls like higher interest rates or higher required down payments. However, there are many lenders and loan types that don’t have a minimum required credit score to qualify. All you have to do is be patient and persistent in your approach to getting a mortgage. Don’t get discouraged too quickly.
Make sure that you weigh all of your options before moving forward with a particular loan. Compare interest rates for multiple lenders and make sure that you are getting the best possible deal. You have about two weeks to shop for a loan without being penalized for multiple credit inquiries. Take advantage of this time to find a lender that is willing to work with you and provide you with a great deal.
Even if you aren’t in a position to buy a house right now, keep working on your credit score. Every on-time payment that you make is helping to build your score for the future!