If you wonder whether a bad credit score might prevent you from getting the home loan needed to achieve homeownership, keep in mind that you may still have options as well as steps you can take to improve your credit utilization ratio or clean up errors in your credit history and get your credit in better shape. While achieving at least a fair credit score expands the mortgage programs and type of loan for which you could qualify, people with bad credit can consider a government-backed loan as well as alternative mortgages for people in challenging credit situations. You can also get help from another borrower to expand your home loan options. Use this guide to learn about how credit ratings affect mortgage options and what you can do.
While lenders will always require that you demonstrate the ability to afford payments on the mortgage amount you take out, they also want to see that you have a history of paying past creditors on time and that you have experience with credit in general.
Exploring Home Mortgages
Available through lenders like credit unions and banks, mortgages provide you with the money to buy a home, condo or another type of real estate. Lenders use your financial information like your payment history, late payments, experience with personal loans, credit score, debt-to-income ratio (DTI) and income stability as well as the property's appraised value to determine whether they should approve you and for how much. Taking out a mortgage involves a process where you go through underwriting to verify your creditworthiness as well as often pay some money upfront – both a down payment toward the home price and closing costs toward various expenses.
You can find various loan options with different interest rate structures, lengths and requirements. For example, you might take out a 30-year mortgage with a fixed interest rate so that you have a better idea of how much you'll pay each month. You could also take out a 15-year mortgage with an adjustable interest rate to reduce the monthly payment amount early during the loan and then possibly see a rate hike later.
Regardless of the arrangement chosen, you'll pay the mortgage each month until you reach the end of the term. Failing to do so might lead to the foreclosure process since the home is the lender's collateral for the funds you borrow.
Read More: Can I Buy a Home With Bad Credit?
Understanding Credit Score Classification
Mortgage lenders will usually pull your credit reports from a few or all of the three bureaus – TransUnion, Equifax and Experian – and consider the credit scores calculated from those reports. They usually use the Fair Isaac Corporation (FICO) score model that has a range between 300 and 850 for credit scores. A bad credit score will be less than 580 under the FICO model, and one that ranges from 580 to 669 is fair. A good credit score begins at 670, while you'd have a very good score at 740 and an exceptional credit score at 800.
You might find that your credit score changes often depending on how you manage your accounts and use credit. The majority of your credit score (65 percent) is determined by the amounts you owe on existing accounts (30 percent) and your history of making payments (35 percent). The other 35 percent includes your new credit applications (10 percent), variety of credit accounts (10 percent) and length of time you've used credit (15 percent).
Note that information on a credit report can vary as well, and this affects credit score calculations. Different creditors may report at different times or not report at all to certain bureaus, so your FICO score can vary by the credit bureau.
Read More: What Credit Score Do I Need for a Mortgage?
What Credit Scores Mean for Mortgages
While lenders will always require that you demonstrate the ability to afford payments on the mortgage amount you take out, they also want to see that you have a history of paying past creditors on time and that you have experience with credit in general. This means that most mortgage programs you find will have a minimum credit score requirement you have to meet even if you already fulfill the other requirements for a loan. Therefore, having a bad credit score limits you to fewer loan options than a fair or good credit score, and if the score is below 500, you may have to look into alternatives or take time to work on your score before qualifying through any method.
Borrowers falling into any category of credit scores also need to be aware that the number will affect the cost of borrowing since lenders offer interest rates that will vary by credit score alongside all the other factors. When you pay a higher interest rate, your mortgage payment increases so that you have a bigger obligation in your budget. Adding up the extra interest over a 15- to 30-year mortgage term can lead to many thousands of dollars extra when you have a lower credit score compared to someone with a good score.
You can use the mortgage interest rate simulator offered on the Consumer Financial Protection Bureau website to see the difference between rates by credit score in your location. This tool takes information such as a property price, down payment, loan amount, credit score range, loan type and loan term to provide you with different scenarios.
Read More: Credit Scores for Mortgage Rates: How It Works
Determining Where Your Credit Falls
Before learning about mortgage programs based on creditworthiness, you should first find out where your credit score falls on the scale to identify the best options. While you might think you have a bad credit score, you could actually have one that is fair and thus opens up more options than you expected. You can get your credit score through both paid and free services. But regardless of which service you use, you'll want to keep in mind that the scores available to you often provide a helpful estimate rather than the exact number mortgage lenders would see when they pull your credit file.
If you prefer getting a free credit score, start by finding out if your bank or creditor gives you a free monthly score on your online portal. If not, you can try financial monitoring websites like Credit Karma or locate a non-profit credit counselor in your area who may provide a credit score as part of their services. If you don't mind paying, myFICO will sell you your score, and the three credit bureaus have their own credit monitoring services that calculate your score on a regular basis.
Read More: How to Check Your Credit Score
Identifying Bad Credit Mortgage Options
Good both for first-time home buyers and anybody with poor credit, Federal Housing Administration (FHA) loans have the most lenient credit requirements as well as allow for a relatively low down payment. You'll need your credit score to be 500 or higher to benefit from this program, and if the score's not at least 580, you'll have to commit to a 10 percent down payment rather than the 3.5 percent more creditworthy borrowers can put down. The good news is that FHA loans offer flexibility in where you get those down payment funds, so you don't necessarily need to have a large amount saved to qualify.
FHA loans do come with some restrictions to know about. For example, you'd have to reside primarily at the home for a year and choose a qualified property. While people with higher credit scores get more flexibility, someone with bad credit would need to have maximum DTI ratios of 31 percent on the front end and 43 percent on the back end to get this kind of loan. There are also mortgage insurance premiums that include an upfront amount and then an annual premium that doesn't get canceled unless you can refinance later.
If you have bad credit but can't meet the FHA's requirements, you could consider non-qualified mortgages that are based on other financial measures like your assets or a high income. You'll find these products through special lenders who usually require a higher down payment and charge higher loan fees and interest. While the lenders underwriting these loans have more flexibility in the borrowers they approve, keep in mind that some may still want credit scores at least in the fair range. So, it's important to both weigh the risks and benefits of such programs and talk to multiple lenders before you proceed.
Read More: Home Loans for First-Time Buyers: A Guide
Considering Fair/Good Credit Home Loans
If you find that your credit score falls at 620 or higher, then you'll find you gain access to a handful of additional mortgage options beyond FHA loans and non-qualified mortgages. Here are some fair and good credit home loans and their minimum credit score requirements:
- Conventional loans (620+): Available to those on the lower end of the fair credit score range, conventional mortgages come with benefits like attractive interest rates, flexibility for property purchases and low down payments (3 to 5 percent). You can have a higher DTI ratio for these loans, and any PMI you pay is canceled once requirements get met.
- Department of Veterans Affairs (VA) loans (620+): Allowing for a minimum credit score on par with conventional loans, VA loans provide borrowers with a military affiliation as a service member with funding that requires no down payment. The VA allows you to use the loan for property purchases, restorations or new builds, and there's just an upfront fee rather than mortgage insurance you'd pay with each monthly payment. There is a stricter 41 percent back-end DTI for these.
- U.S. Department of Agriculture (USDA) loans (640+): Usually requiring a higher credit score than VA and conventional loans, USDA loans also require nothing down but limit borrowers to properties in a rural area and require maximum income limits by area. These loans give you the flexibility to build a new house rather than buy an existing one if you'd like. This program has the tightest DTI ratio requirements of the options and requires fees annually and upfront.
- Jumbo loans (700+): Requiring good credit and a more sizable down payment, jumbo loans become necessary when your loan amount exceeds the typical limits set by location. You can expect to pay more interest and fees and have a conservative DTI ratio.
Read More: Buying a Home Programs: What You Need to Know
Solving Mortgage Credit Challenges
If you're buying the home with someone else who has better credit, applying with the other person means the lender still takes your low credit score into account. So, as an alternative, you might consider allowing that person to apply for the mortgage without you so that the lender only considers their credit score for approval. The downside of this is that the lender wouldn't consider your income anymore, and this will reduce the buying power. On the other hand, if your credit is low but still meets the minimum, you can apply with the other person with the tradeoff that the mortgage rate may be higher doing so.
Whether you want to apply alone or just get the best rates, postponing your home purchase so you can fix your credit score might be right for you and offer additional benefits. For example, paying off credit cards or other loans can boost your score and lower your DTI ratio to help with approval. In any case, use strategies like paying extra on debts, keeping accounts open and current, handling credit report errors and limiting new credit applications while you plan for your mortgage.
Read More: Requirements for a Mortgage Cosigner
Learning About Your Approval Chances
To better understand how having bad credit might affect the mortgage application process, meet with a few mortgage lenders to go through a prequalification or preapproval process. During this process, the lender typically pulls your credit and looks at all your other financials to assess which mortgage programs could work for you. Since you'll end up both with potential loan terms and an answer about the likelihood of approval, you'll know whether you need to consider other solutions before you start the homebuying process. If the lender offers a satisfactory loan program, you can agree to go ahead and find a home and continue with the mortgage loan application process.
- Consumer Financial Protection Bureau: Buying a Home? The First Step Is To Check Your Credit
- Consumer Financial Protection Bureau: Explore Interest Rates
- Rocket Mortgage: How to Qualify For A Mortgage
- Consumer Financial Protection Bureau: How Does My Credit Score Affect My Ability To Get a Mortgage Loan?
- myFICO: What Is a Credit Score?
- myFICO: What's in My FICO® Scores?
- Lending Tree: Minimum Mortgage Requirements for 2021
- Consumer Financial Protection Bureau: FHA Loans
- Consumer Financial Protection Bureau: Conventional loans
- U.S. Department of Veterans Affairs: Purchase Loan
- U.S. Department of Agriculture: Single Family Housing Guaranteed Loan Program
- Quicken Loans: Jumbo Loan: Definition, Rates And Limits
- Consumer Financial Protection Bureau: Making the Move to Homeownership on Your Own or With Someone Else
- The Federal Reserve Board: 5 Tips for Improving Your Credit Score
- Consumer Financial Protection Bureau: Mortgages Key Terms
- Federal Trade Commission: Shopping for a Mortgage
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.