Whether you want to purchase your starter home or upgrade to your dream home, you might wonder whether having a bad credit score due to issues like a late payment history, foreclosure or past bankruptcy will prevent you from getting approved for a mortgage program that leads to homeownership. Depending on your specific score, you could have at least one government-backed option to consider alongside some non-traditional financing options. Those with fair or good credit scores and larger down payments can qualify for more loan types than those with poor credit, and getting a co-signer's help is another possibility. Use this guide to learn all you need to know about buying a home with a home mortgage when you've got a bad credit score.
1. Understand What Bad Credit Means
Although there are a few credit scoring models used that assign different weights to specific aspects of one's credit use, the credit score scale is usually between 350 and 850; the higher the credit score, the better. According to the Fair Isaac Corporation (FICO) credit scoring system used most by lenders, the definition of a bad credit score usually is one falling under 580 on this scale. Such a number makes lenders consider you riskier when giving you a mortgage.
While FICO credit scores from 580 to 669 are considered just fair rather than good, they open up options for most mortgage programs. Scores from 670 to 739 are good, those from 740 to 799 are very good and those 800+ are exceptional.
Read More: FICO Score vs. Credit Score: What's the Difference?
2. Know Bad Credit Score Effects
The main problem with having a low credit score is difficulty qualifying for a home loan. Most of the mortgage programs you find want to see at least a 620 to 660 minimum credit score, so falling in the under 580 range, well below minimum credit score requirements, limits you to one government-backed mortgage program along with some nontraditional options.
There's another issue to consider: your potential interest rate. The risk a lower credit score presents to lenders results in having to pay higher mortgage rates, which results in higher mortgage payments. You'll see this in a higher monthly payment and more paid over your mortgage term. Borrowers with bad credit can also face higher down payment requirements.
3. Find Out Your Credit Score
You'll need to find your estimated credit score to get a better idea of potential homebuying program loan options. Paid options include using the myFICO website or subscribing to a credit monitoring service such as those through the credit bureaus. You may not need to pay anything, however, since a financial institution you work with might provide a free monthly score as a customer benefit. Websites like Credit Sesame and Credit Karma also provide free scores as well as tools that can help you simulate how certain financial actions – like paying down an account or keeping a good payment history for a set time – will change your score. You can also get a free credit report once a year, but this will not have your credit score.
In any case, keep in mind scores can change and the many scores you see through these options may not match what lenders ultimately see upon a credit pull. So, you might consider the number you see as an estimate that guides you on whether you need to work on your credit or whether you're in good shape to move forward with the homebuying process.
Read More: How to Check Your Credit Score
4. Seek Federal Housing Administration (FHA) Loans
When you check out the different mortgage programs available, you'll find that the most flexibility for people with a bad credit score exists through government-backed FHA loans. Compared to other programs that require a 620 or higher credit score, the FHA loan program can help borrowers with a bad credit score of 500 or higher, although it's up to the lender who can ask for a higher minimum score. This lenience comes with the condition that someone with a credit score below 580 has to have a 10 percent down payment versus the 3.5 percent amount for those more creditworthy.
When going with this loan option, you'll want to keep a few things in mind. First, certain properties such as condos need to have FHA approval for financing. Second, an FHA loan comes with mortgage insurance costs through annual and upfront premiums that you'll want to take into account for your total cost of borrowing. As long as you understand these limitations, FHA loans might be the best mortgage option for becoming a homeowner with bad credit.
5. Explore Other Potential Mortgage Programs
If your credit lies in the range of 580 to 669, then you may have more home financing options open to you even if you don't qualify as someone with "good" credit. Consider these other programs and their credit score requirements:
- Conventional loan: Lenders usually set the baseline credit score at 620 for these popular loans that don't have government backing. Conventional loans attract borrowers seeking a low down payment requirement – usually 3 percent – and who want flexibility with qualifying properties and loan terms. Borrowers usually need a competitive financial profile to qualify for a conventional mortgage, and they pay for private mortgage insurance when the down payment made is under 20 percent.
- U.S. Department of Agriculture (USDA) loan: Appealing to borrowers who both have little cash set aside for a down payment and are house shopping in a rural area, USDA loans usually require a 640 credit score and low DTI ratios. A borrower's income must not exceed the county limit, and those who qualify don't need to make a down payment in most cases. Borrowers pay guarantee fees upfront and annually.
- U.S. Department of Veterans Affairs (VA) loan: Designed to benefit those who've served the country in the military and those who've been married to service members, VA loans are similar to the USDA program with the flexibility to avoid a down payment. They usually require a 620 credit score and conservative DTI ratio, and borrowers have to obtain a Certificate of Eligibility to make sure their military service qualifies. Borrowers pay a one-time fee when the loan gets originated.
On the other hand, someone with a score in this range would likely have trouble getting another option available called a jumbo loan. Borrowers would need this to buy a house that costs above the conforming loan limit in their region, and lenders want a high credit score – often 700 or above – along with a more sizable down payment and lower debt-to-income (DTI) ratio to feel confident about giving someone this high-value loan.
6. Make Sure You Meet Other Requirements
To get a mortgage with bad credit, you'll need a suitable credit score as well as meet all the other requirements set by the mortgage program and/or lender. They often include these items below:
- Debt-to-income ratio: Lenders calculate ratios that consider your income along with either the housing payment or all your debt payments. The one based on the housing payment is the front-end ratio, while the back-end ratio includes all the debt payments including credit cards. Depending on the monthly payment and your financial profile, the back-end ratio maximum can fall between 41 and 50 percent. The front-end ratio usually shouldn't exceed 31 percent if the lender requires it.
- Steady employment: Making enough money for a good DTI ratio usually isn't enough for a lender considering your loan application since they need to trust that your income will stay that way for the foreseeable future. This usually means the lender examines your most recent two years of employment to see how wages have fluctuated and look for job gaps. Self-employed borrowers often have their calculated annual income adjusted by the lender when deciding on a loan amount when wages fluctuate over the period.
- Cash reserves available: Mortgage lenders will look for how you plan to pay the 0 to 20 percent minimum down payment your mortgage program may require along with the 2 to 6 percent for closing costs. Unless you'll get the funds through an assistance program or a gift, you'll need bank statements documenting the cash on hand.
- Qualifying property: The type of real estate and purchase price need to fall within the mortgage program's requirements. Some programs also restrict occupancy requirements such as requiring that you use the property as a primary home rather than a vacation home. The property will need to appraise to a current value reasonable for the amount of mortgage loan you're requesting.
7. Consider Using a Co-Signer
Whether you want to boost your chances of getting an FHA loan or have bad credit but want an opportunity to apply to one of the other mortgage programs, obtaining a co-signer may persuade your lender to consider you more seriously as a borrower. This decision can also help with getting a larger loan or meeting income requirements when your income is otherwise unsteady.
While a co-borrower usually owns the property with you and mortgage lenders usually take the lower credit score into account, a co-signer differs in that they mainly take responsibility for your mortgage in case you can't pay. They may be a friend or family member, and lenders may specify allowed relationships. In many cases, the co-signer won't live in the home but just be willing to take the financial risk for you, but certain loan programs will require the co-signer to be on your home's title. You'll want to consider the risks on both sides to determine if this option seems right.
Read More: Requirements for a Mortgage Cosigner
8. Improve Your Bad Credit Score
While a FICO score gets calculated based on five criteria, two factors have the most weight: how much you owe on all the accounts (30 percent) and how you've handled your payments over time (35 percent). The types of credit accounts you have, the length of time you've had a credit history and how many new credit applications you've submitted play a smaller role but are also worth considering.
With this information in mind, you can opt to improve your situation before heading to the lender and thus have more mortgage loan options and a higher likelihood of qualifying. Here are some possible next steps:
- Improve your credit utilization by chipping away at high-balance accounts or pay one or more in full; avoid running up charges again too.
- Resist opening new credit accounts during the mortgage application process.
- Make sure your credit report doesn't have mistakes that hurt your credit score.
- Don't miss any payments due; use tools like auto-pay or notifications to remember.
- Get past-due accounts resolved as soon as possible to avoid further issues like the account going to a collections agency.
- Consider letting time pass to lengthen your credit history and reduce the effect of past credit blemishes.
9. Work With a Mortgage Lender
While you can do research, a lender can offer personalized help and solutions for a bad credit situation. To find out what might work for you, check with a few lenders either locally or online and ask about their experience helping borrowers with bad credit.
Lenders will likely suggest going through a preapproval or prequalification process so they can get a better look at your finances and give an initial response on whether they can offer you some type of mortgage. By simply providing some basic financial data and getting your credit checked, you can learn about potential mortgage programs and terms and then decide to either proceed, seek other options or wait for your home purchase.
Lenders can also share information on programs for first-time homebuyers that can offer helpful funds. For example, you might get several thousands of dollars in a grant toward a down payment or get access to low-interest loans that can help with paying closing costs.
Read More: What Are the Signs of Credit Overuse?
10. Look Into Traditional Mortgage Alternatives
If lenders can't offer a solution through the regular mortgage programs available, you can look into non-traditional mortgages and seller financing as potential options for people with bad credit.
Lenders offering non-qualified mortgages may look at other financial criteria like your income or recent credit history rather than require a specific credit score. You might put more money down, get offered higher mortgage interest rates with higher monthly payments and submit thorough documentation on income to get this loan.
Some sellers will decide to offer financing to buyers who may not meet traditional mortgage criteria. This is often a temporary arrangement where the borrower gets a payment schedule and term, pays the money to the seller and then needs to find a regular mortgage for a balloon payment at an agreed-upon date.
Read More: What Is Home Finance by Owner?
- HUD: Let FHA Loans Help You
- LendingTree: Minimum Mortgage Requirements for 2021
- Consumer Financial Protection Bureau: Where Can I Get My Credit Score?
- myFICO: What Is a FICO® Score?
- Consumer Financial Protection Bureau: How Do I Get and Keep a Good Credit Score?
- myFICO: What's in my FICO® Scores?
- Consumer Financial Protection Bureau: Explore Interest Rates
- Consumer Financial Protection Bureau: What Is "Seller Financing"?
- Diamond Residential Mortgage Corporation: Non-QM Loans
- Consumer Financial Protection Bureau: Get a Prequalification or Preapproval Letter
- U.S. Department of Veterans Affairs: Purchase Loan
- U.S. Department of Agriculture: Single Family Housing Guaranteed Loan Program
- Consumer Financial Protection Bureau: Conventional Loans
- Consumer Financial Protection Bureau: What Is a Jumbo Loan?
- Consumer Financial Protection Bureau: A Friend Asked Me To Be a Co-Signer on a Mortgage Loan. What Does That Mean?
- Quicken Loans: How to Get Approved
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.