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When you don't understand your options, it might seem like bad credit automatically disqualifies you from the prospect of homeownership. However, that might not necessarily be the case.
You might qualify for unconventional financing options and possibly a conventional mortgage depending on your income, credit history, and the size of your down payment.
Here’s how to buy a house with bad credit:
- Get your credit report.
- Determine how much you can raise in down payment.
- Choose a financing option.
- Apply for financing and wait for approval.
Read on to learn more about these financing options, their benefits, and their eligibility criteria.
Defining "Bad Credit"
To ensure we're on the same page throughout the rest of this discussion, let's define what qualifies as "bad credit." Experian uses five adjectives to define the various credit score ranges:
- Poor: 300 to 579
- Fair: 580 to 669
- Good: 670 to 739
- Very good: 740 to 799
- Excellent: 800 to 850
When I talk about "bad credit," I'm referring to credit scores under 670. Now that we're on the same page, let's get to the good stuff.
How to Buy a House With Bad Credit
Here’s how to go about buying a house with bad credit:
1. Get your Credit Report
The first thing you’ll want to do is request your credit report. Prospective lenders will need it to evaluate your creditworthiness. Reviewing your report can also reveal a few things that you can do to bump up your credit score before applying for financing. Examples include:
- Paying for collections deletion
- Adding new accounts
- Paying off credit card debt
- Requesting a credit limit increase
By increasing your credit score before you apply for financing, you may increase your chances of being accepted for a loan.
2. Determine How Much you Can Raise for the Down Payment
Figuring out your down payment in advance helps determine how much you’ll need to finance, which can be handy when choosing a financing option. The higher your down payment, the less you’ll need to finance and the more likely you are to qualify for favorable interest rates.
To figure out how much you can pay for a down payment, you’ll need to write out a budget. A good rule of thumb is to have at least three mortgage payments in reserve, not including the down payment.
By writing out a budget, you’ll have a better idea of what you’re able to afford.
Interestingly, a 20% down payment was once the standard for home-buying but today, most people are paying five percent or less. Remember, a higher down payment helps reduce your mortgage payments and it makes you more attractive to sellers.
Smart Asset offers a free online calculator that can help you determine the minimum down payment depending on the value of a home.
3. Choose a Financing Option
Depending on your credit score and whether you’ve served in the military, you have several financing options for a home buying loan. These include:
- An FHA loan
- A VA loan
- A USDA loan
- A conventional loan
Let's take a deeper look at each of these in greater detail to help you choose the right option.
An FHA Loan
An FHA loan is a type of mortgage insured by the Federal Housing Administration. It's primarily geared towards first-time homebuyers with non-stellar credit scores, with more lenient borrowing terms than conventional mortgages.
Here's what makes an FHA loan an attractive financing option:
- A low credit score threshold. The minimum required credit score is 580 if you can make a 3.5 % percent down payment. If you bump up the down payment to 10%, the credit score threshold drops to 500.
- A borrower-friendly down payment limit. As long as your credit score isn't below 580, you only need to raise a down payment of 3.5%. Sure, some conventional mortgage lenders may accept a 3% down payment, but they require a higher credit score to approve the loan in the first place.
- Favorable interest rates. While an FHA mortgage's Annual Percentage Rate (APR) usually exceeds that of a traditional fixed-rate mortgage by 1.5 to two points, it's not all that bad if you consider a few factors:
- First, traditional fixed-rate mortgages are typically offered to individuals with excellent credit.
- Second, the introductory rates on subprime mortgages tend to be higher than an FHA loan's APR.
- Last but not least, the interest rates in most subprime loans aren't fixed like in an FHA loan, meaning they can shoot up after the three-to-five-year introductory period.
For the above benefits, there's a price to pay: compulsory mortgage insurance. Its purpose is to cushion lenders against the typically higher loan default rates associated with "bad credit" borrowers.
Here's how borrowers are required to cover the insurance cost:
- Pay 1.75% of the loan amount upfront at closing. If you can't afford to raise this amount, you can roll it into your loan financing, along with other closing costs.
- An annual insurance premium of 0.45% to 1% is added to the borrower's monthly loan payments. The exact size of the annual insurance premium depends on the size of your down payment, the loan amount, and the loan term.
A VA Loan
A VA loan is yet another government-backed loan, but this time insured by the Department of Veterans Affairs. VA loans are only available to certain former and current members of the armed forces 一 you can find the full list of eligibility criteria on the website for the United States Department of Veterans Affairs.
In addition to meeting the VA eligibility criteria, you also need to meet your lender's income and credit requirements. Specifically, your financials need to demonstrate your ability to cover the monthly payments.
And while there's no credit score threshold for this type of home loan, lenders may set their own limits. More often than not, that limit is a credit score of at least 620, so you may still qualify even with "bad credit."
A USDA Loan
USDA home loans are geared towards homebuyers with incomes in the low-to-moderate bracket. Along with VA loans, USDA loans are among the few financing options that don't require a down payment.
And like many other government-backed mortgages, USDA loans come with favorable interest rates. To qualify for one of these, you need a FICO score of at least 620.
You also need to meet USDA income and property eligibility criteria. Understand that while 620 is the limit, you'll need a slightly higher credit score of 640 to qualify for USDA's automated underwriting system.
If your FICO score is under 640, you might still qualify through manual underwriting, where a lender manually examines your financials to determine your creditworthiness.
Keep in mind that this process takes longer than automated underwriting, and you're not guaranteed loan approval — your financial history plays a huge part in that.
A Conventional Loan
A conventional mortgage loan can also be an option for individuals with credit scores between 620 and 670. And while 620 is often the minimum credit score requirement for a traditional mortgage, you might qualify for one with a slightly lower score if:
- Your income is high relative to the loan amount.
- You can raise a significantly larger down payment than the lender's minimum.
- You don't have any collections on your financial records.
Applying for a conventional loan with bad credit comes with a major caveat: higher interest rates. The lower your FICO score, the more you're likely to pay in interest.
To help lower your interest rate and increase your loan amount, consider enlisting a cosigner with better credit than you. The biggest challenge is finding a person who's willing to put their credit score and savings on the line for you.
If you default, the cosigner will be liable to pay. If they fail to pay, their credit score will be negatively affected.
4. Apply for Financing and Wait for Approval
Depending on the type of financing you choose, you might have to wait between a week and 60 days. Government-insured loans generally take between 30 and 60 days, while conventional mortgages take two weeks or shorter.
If you get approved, all that remains is to iron out the home purchase details and you’re all set to become a homeowner. If you don’t get approved, improve your credit score and try again.
Evidently, you still have some financing options as an aspiring homeowner with bad credit. However, you might be better off working on your credit score before applying for financing.
That's especially true if your credit score is significantly lower than 670, and you don't qualify for FHA, VA, and USDA loans. Applying for a conventional mortgage with bad credit can be costly in the long run.
Even with a cosigner, the loan terms might not be as favorable as you'd get with good credit.