How to Buy a House With Bad Credit?
What You Should Know
- It is very difficult to find a mortgage with a credit score under 500. Borrowers with a credit score under 500 might be better off building their credit history first.
- There are multiple types of mortgages (e.g. FHA Loans, VA Loans & USDA Loans) available for people with a bad credit history.
- In most cases, Private Mortgage Insurance is required for people with a bad credit history.
- Many factors are affecting the credit score. Even though it might take a while, it is possible to improve credit history.
Step-by-Step Guide for Buying a House With Bad Credit
If you are worried that you might not qualify for a conventional loan and do not know where to start, this step-by-step guide will help you to plan a strategy to buy a house with bad credit. Before proceeding with getting a mortgage with a bad credit score, it is important to understand that you may have to pay extra interest for the loan.
This extra interest may add up quite a bit over time because of the large principal outstanding. If you do not have a significant reason to purchase the property, it might be wise to increase your credit score before attempting to get a mortgage.
- 1. Check Your Credit Score
The first step in the process is to see whether your credit score is above the threshold of 500 points. It is possible to receive a free credit report from each of the credit bureaus at least once a month. This report will show your credit score and all the credit lines you have on file whether it is a credit card, car loan, business loan, or anything else. Three major credit bureaus calculate credit scores in the USA.
The banks usually pull credit scores from these bureaus. They also tend to focus on the lower score of these three credit bureaus. For example, if your Equifax score is 600, Experian score is 550, and TransUnion score is 575, the credit score the bank will see will be 550. On the other hand, it might be the case that only one agency has the score available for you. In this case, the lender will use the available score, and they might ask for extra documents to supplement the credit score.
Because of this practice, it is important to check all three credit bureaus and see where you stand. If there are any inconsistencies in the credit report between the bureaus, you can dispute them with the respective credit bureaus or the banks. For example, if you have 2 credit cards, but only one credit card is shown in the credit report, then you can ask the bank to provide the information about your credit card to the credit bureau. This way, the credit bureau can adjust your credit score based on all the information available.
- 2. Consider the Mortgage Options Available
- 3. Estimate Your Budget
When you find the mortgage that fits your objectives, it is important to understand how much you have to put in for a down payment and how much a bank is willing to lend you on top of that. The best way to estimate your loan amount is to request a mortgage pre-approval from your lender.
The pre-approval letter should state what amount your lender is willing to lend you for the mortgage. Sum up the amount of money you have for the down payment and the amount you can take out as a loan to estimate the price of the house you can purchase. Be cautious, just because you can purchase a house, does not mean you can necessarily afford it.
Make sure that your income can cover monthly mortgage payments and support your lifestyle. Excessive borrowing may lead to large loan payments that a person may not be able to keep up with resulting in a default.
- 4. Find a House Within Your Budget and Close the Deal
When you have an idea of how much you can spend on the house, you can start looking at the houses on the market. You can contact a real estate agent who can help you find a house that fits your budget and your preferences.
Make sure to look for the house you can afford considering your income and spending habits. Just because you are pre-approved for a certain amount of money does not mean you can afford to spend them all. When you find the house you can afford and want to purchase, contact your real estate agent to prepare all the necessary documents to close the deal.
Based on your credit score, you may have different mortgage options available to you. If no mortgage options available fit your objectives, then it might be wise to clean your credit history before buying a house. Make sure to learn how to get a mortgage with bad credit to have a clear understanding of what options are available in your case.
If your credit score is below 500, then it might be very difficult to find a mortgage lender who would qualify you for a mortgage. Even if a lender agrees to issue a mortgage, the interest rate may be much higher than for a person with a higher credit score. Buying a house implies taking on a lot of debt for an average person, and even a slight increase in interest rate may be very costly over the lifetime of the mortgage. If your score is below 500, it is suggested to build your credit history and increase your credit score before buying a house.
If your credit score is between 500 - 640, then you should look for a mortgage that is backed by government agencies. These mortgages include FHA loans, VA loans, and USDA loans. The mortgages backed by the government agencies carry a lower risk to the lender, so they are willing to issue these types of loans for people with lower than average credit scores. It is important to understand whether you can qualify for the loan you are applying for because they have certain criteria that must be satisfied to be eligible.
If your credit score is above 640, then you may be able to qualify for a conventional loan as well as any government-backed loan. With a score of 640 and above, it should not be a problem to find a mortgage lender who would approve your request. The loan amount you can be approved for may depend on your credit score and income.
Options For Buying a House With Bad Credit
Starting a home-buying journey with bad credit may seem overwhelming or even impossible. It might not be easy to find a lender who would be willing to lend money to an individual with a bad credit history, but there are still some mortgage types that can be available.
|Mortgage Name||Minimum Credit Score||Who is Qualified|
|FHA Loan||500 - 580||First-time home buyers with low credit scores|
|VA Loan||580 - 620||Veterans and armed forces|
|USDA Loan||640||Rural area home buyers|
|Freddie Mac Home Possible||620||Homebuyers with low to medium income|
|Fannie Mae HomeReady||620||Homebuyers with low to medium income|
Generally, mortgage lenders do not require a specific credit score to qualify for a mortgage. They assess the suitability of mortgage requests using various criteria where credit score does not play the main role. For example, mortgage lenders may be willing to issue a loan to a person who may not have a high credit score but have a high salary compared to the amount required.
On the other hand, it might be extremely difficult to find a lender who is willing to approve a loan for an individual with a FICO score of less than 500. A person with a credit score of 500 or less may be better off focusing on improving their credit score before looking for a mortgage.
A mortgage lender looks at various factors when issuing a loan. People are different and the circumstances of two people with the same credit score may be different too. Because of that, the lenders look at other financial factors to determine whether a potential borrower can be approved for a loan. These metrics usually include the following:
- The price of the property that is being bought on a mortgage.
- The amount of money the borrower puts as a down payment.
- The amount of debt the borrower currently has.
- The income and assets of the borrower.
- The presence of debts of the borrower that are currently in collections.
Being able to contribute to down payment is the most important factor in issuing a mortgage. Lenders tend to have the mortgaged property as collateral for the mortgage. In this case, if the buyer puts a higher down payment, then they have more incentive not to miss payments to avoid pre-foreclosure on their property. Additionally, if the default occurs, it might be easier to recover the debt outstanding if the value of the property is much larger than the mortgage amount.
Other ways may be suitable for some people, to get approved for a mortgage. The US government and quasi-government agencies support certain demographics by backing their mortgage requests. These mortgage loans include:
- FHA Loans
FHA loans are backed by the Federal Housing Administration (FHA) and are available for first-time homebuyers. Since FHA loans are backed by a government agency, the qualifying requirements are much lower than for a conventional mortgage. The minimum credit score for an FHA loan is 500, and it can be used to purchase a primary residence only.
An FHA loan is likely to require Private Mortgage Insurance (PMI). This insurance will require two distinct types of payments by the borrower. The initial payment, which equals 1.75% of the loan amount, is paid at the initiation of the insurance. Annual payment is a recurring annual payment that is paid on top of the loan payments. Annual payment usually ranges from 0.45% to 1.05% from the outstanding principal. This means that annual payments decrease as the outstanding principal decreases.
- VA Loans
VA Loans are available for veterans and people currently serving in the Armed Forces. VA loans are backed by the Department of Veteran Affairs for mortgages with 0% down payment. Some banks may require a one-time funding fee to issue this type of mortgage. There is no minimum credit score required to qualify for the mortgage, but the house bought must meet certain criteria.
- USDA Loans
USDA Loans are backed by the US Department of Agriculture. These loans allow a borrower to purchase a property in a qualifying rural area with a 0% down payment. Just as with any loan, the borrower might need to pay a one-time funding fee to initiate the mortgage. Most lenders require the credit score to be at least 640 to qualify for the loan. Other income-related requirements have to be met to qualify for the loan.
- Freddie Mac Home Possible Loan
This relatively new type of loan was released in March 2015. Home Possible Loan offers first-time homebuyers to get a mortgage with a very low down payment. This program targets low to moderate-income borrowers and offers a mortgage with a down payment of as low as 3%. Home Possible mortgage allows a flexible down payment that may come from different sources such as family, employer assistance programs, secondary financing, and others. This type of mortgage requires private mortgage insurance until the Loan-to-Value ratio is 80% or less. Eligible properties may include 1 to 4 unit houses, condominiums, and planned-unit developments.
- Fannie Mae HomeReady Loan
This loan is offered by the Fannie Mae mortgage loan company, and it was released in December 2015. Low to moderate-income borrowers can be qualified for their loan. It is also very similar to Freddie Mac in a way that it also offers mortgage loans with as low as a 3% down payment. To qualify, it may also include the income of another person living in the borrower’s household to increase the chances of approval. HomeReady loans allow the purchase of first property as well as additional property as long as the requirements are met. They also offer competitive rates for people with a credit score above 680.
- Owner Financing
Another less popular way to buy a house with a bad credit is to find a seller who is willing to provide a loan to the buyer. This technique is called owner financing, and it is used by buyers who cannot get a mortgage and sellers who want a high return on their investment.
Factors Affecting Credit Score
People who do not know what affects credit score might be left wondering why their credit score is so low. Many factors affect credit scores differently, and the best way to understand how exactly a credit score is calculated is to reach out to a credit bureau and ask them specific questions regarding their credit score composition. On the other hand, there are a few known factors that affect credit scores the most:
- Payment History
This factor considers whether a borrower covers debt payments on time. To have a healthy credit history, it is important to pay off all outstanding debt on time. This factor contributes to around 35% of the total score, and one missed payment may negatively affect credit history for a very long time.
- Credit Utilization
Credit utilization refers to the amount of credit used up in a billing cycle relative to the total amount of credit available. For example, if a borrower has a credit card with a $1000 limit using $500 in a billing cycle, then their credit utilization is 50%.
This metric is responsible for about 30% of the credit score. A high credit utilization lowers the credit score of a borrower. As a rule of thumb, credit utilization of under 30% is considered healthy and will not negatively affect the credit score. On the other hand, if credit utilization is higher than 30%, then it might lower the credit score temporarily. A credit score tends to go up as soon as the bills are paid and credit utilization returns to 30%.
- Age of Credit History
Credit bureaus consider how long a borrower has been borrowing money. This is because a borrower with a good credit history of one year is less reliable than a borrower with the same credit history of ten years. The longer a person borrows and pays on time, the more reliable the person becomes in the creditors’ eyes. Usually, the age of credit history is composed using the oldest credit card on file or the average age of all credit cards on file. This factor is responsible for around 15% of the total credit score.
- Types of Credit
Credit bureaus also look at what types of credit a borrower has. Credit types can be revolving credit (e.g. credit cards) and installment loans (e.g. car payments). Credit bureaus consider having a mix of these a favorable factor because it shows that the borrower can manage different types of credit at once. Having multiple types of credit can contribute around 10% to the total credit score.
- Amount of Hard Inquiries Present
The last important factor that affects a credit score is the number of hard inquiries present for the last 6 months. A hard inquiry is made by a lender every time a borrower applies for a loan. The presence of multiple inquiries may suggest that a borrower is taking too much new credit at once, which is considered risky by the creditors. To avoid the negative effects of hard inquiries, a borrower should not apply for multiple lines of credit within the same 6 months. If a credit score is affected negatively by hard inquiries, the effect may last for about 6 months. Hard inquiries are responsible for around 10% of the total credit score.
These factors can help a borrower recognize what they should work on to increase their credit score. There is no quick way to increase a credit score, but there is a strategy that may help raise a credit score sustainably. A borrower who wants to increase their credit score has to make sure to pay off their credit card debt in full to lower credit utilization. Additionally, they should ensure that they do not apply for new loans too often and pay off all debt on time. Lastly, if there is no credit type mix, then applying for a loan that is different from current credit types may help increase credit score by some points.
It is important to remember that lenders do not only consider credit history. They also actively look at the assets in possession, income level, and debt outstanding. It might be possible to contribute some assets as collateral to get approved for a loan or decrease the amount of debt present. Ultimately, there are multiple strategies to get approved for a mortgage with bad credit. Instead of questioning whether a person can receive a mortgage, it is more important to understand what mortgage will meet the person’s objectives.