how to buy a house with bad credit

How to Buy a Home with Bad Credit

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Is it easy to buy a home with bad credit? No, but it’s not impossible to do so. Before engaging in a search for a home, you should find and review your latest credit report and credit score. There is quite a financial difference in the thousands between paying a monthly loan based on a bad credit score and an excellent one.

You want to know where you stand as a potential creditworthy borrower. There may be errors on your credit report that you can be easily correct.

By itself, it is overwhelming to buy a house. The home buying process can be intense and emotional between buyers and sellers, brokers, inspectors, lenders, and attorneys. Having bad credit adds a significant hurdle. Unless you have substantial liquidity and pay cash for the house in full, you will have to rely on a lender who will provide a mortgage.

What Is A Credit Score?

A credit score reflects your creditworthiness based on an analysis of your credit information provided by the three credit bureaus, resulting in your credit report. The FICO scoring system ranging from 300-850 remains the predominant model used by financial institutions. Your creditworthiness increases with the higher the score.

 

Various people may ask for your credit report and credit score. They are lenders, landlords, employers, cable companies, utility providers or even to obtain a smartphone, a prospective business or life partner. Your creditworthiness reflects your attitude on your finances and paying your bills on time.

What Is Considered A Bad Credit Score?

Generally, there is no stated specific minimum credit score that all lenders will universally accept you and give you a loan. The lower your credit score, the higher the risk for the lenders to view you as a borrower. They may lend you money, but you will be paying a higher monthly loan amount. Others may pass on giving you a loan.

All lenders have different requirements. Once you accept the probability of paying a higher interest rate, recognize that you can improve your credit score and refinance your mortgage later on. It may be challenging, but it will be financially worthwhile to make this one of your priorities.

Some lenders may accept a larger down payment (e.g., 20% or more of the home’s price) to offset a lower credit score. Typically, you will have more borrowing opportunities in the 670 or higher range than below 580, where it will be pretty challenging.

FICO Credit Score Ranges Per Experian:

  • 800-850 Exceptional
  • 740-799 Very Good
  • 670-739 Good
  • 580-669 Fair
  • 300-579 Poor

 First, let’s talk about how the FICO Scores formula works using information from your credit report. They use five criteria that are proportionally different in value.

Payment History  (35%)

 Payment history accounts for 35% of your credit score. It carries the most significant weight in your score. This is one area in which you have considerable control. Lenders want to know if you have paid past credit accounts on time. Any late payments will dent your score on this critical factor. You need to exhibit an excellent track record of not missing payments for the length of any credit outstanding.

Those who are new to being approved for their credit cards need to show a consistently positive pattern. 

Amounts Owed  (30%)

Amounts owed reflects on your credit utilization. Lenders do not want you to use a significant amount of your available.

A significant influence on your credit score, credit utilization is the ratio of your total outstanding revolving credit balances divided by full available credit. Revolving credit refers to your credit cards and credit lines you may have but does not include your car loan (unless on your credit card) or your mortgage.

The utilization ratio is known as the balance of debt to available credit or debt-to-credit. It measures how much credit you have used for the amount available to you. You don’t want to “max out” your credit cards.

Having a  30% or higher utilization ratio tells the lender you are using too much credit, impacting your score. I would stay in the mid-20s range so as not to hit the 30% level. To an extent, you have more control over this factor, like payment history. 

 Length of Credit History (15%)

How you handle credit is essential to lenders. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. When you are just getting your credit card and borrowing, your credit history is short and out of control. The older the account, the better your credit score. If you are new to obtaining credit, it will take time to benefit from showing up in your score.

Don’t Close Any Accounts

You should not do some things, such as closing an account because of not using them actively. Closing a credit card can negatively impact your score in two ways. First, the longer your credit history, the better, so you don’t want to close an older card. At the same time, you will take away the available credit on that card, raising your overall credit utilization rate. Rather than closing your account, leave the card in a drawer where it will do little damage.

 Credit Mix  (10%)

Lenders favor some variety of borrowing in your mix of credit. A borrower handling different kinds of debt products may reflect less risk to lenders. When you don’t yet have a credit card, you may be at higher risk. Don’t go out and apply to get different kinds of loans for the sake of improving your mix. 

New Credit (10%)

When you apply for new credit, a creditor will review your credit file to assess how much risk you pose as a borrower. As such, it results in a “hard” inquiry on your credit report for up to two years. Hard inquiries can negatively impact your credit score, particularly if you are making multiple inquiries. However, don’t let it stop you from doing comparison shopping for the same type of loan.

A soft inquiry occurs when you are checking your credit score or report. Soft inquiries do not generate negative hits. Avoid getting new credit simply because you lack credit history. Over time, you should apply for what you need. 

 How Much Of A Difference Does A Credit Score Make On Your Loan?

According to the following credit scores, using myFICO Loan Savings Calculator,  here are national 30 year fixed mortgage rates with a $300,000 loan on May 26, 2021. The higher the score, the lower the monthly payment. The difference between $1,204 and $1,469 may not seem that vast for one month. However, over 30 years, these costs have become significant. 

      Scores              APR                  Monthly Payment

  • 760-850    2.624%                 $1,204
  • 700-759    2.846%                 $1,240
  • 680-699    3.023%                 $1,269
  • 660-679    3.237%                 $1,303
  • 640-659    3.667%                 $1,375
  • 620-639    4.213%                 $1,469

 

Besides your credit score, lenders will consider your debt-to-income, loan-to-value ratios, and cash reserves as indicators of your overall financial health. They are looking for clues to inform them how comfortable you are with paying down your debt. 

Debt-to-Income Ratio

The debt-to-income ratio or DTI compares how much you owe each month relative to your monthly earnings. Specifically, it’s a percentage of your gross monthly income before taxes that covers your monthly bills, including monthly rent or mortgage, student loans, car payments, credit card payments. Divide the total amounts by your gross monthly income. The lower the DTI, the less risky you are to lenders. Most lenders would prefer a DTI below 36%, with a DTI of 20% is considered excellent.

Loan-To-Value

The loan-to-value (LTV) ratio is typical ratio lenders use to express that amount of borrowing to the appraised value of the asset purchased, such as a home.

High LTV ratios indicate that the borrower is putting a lower down payment on the home they are buying. The calculation is straightforward: divide the loan amount by the asset’s appraised value, which secures the loan as collateral to the lender. A typical LTV is 80%, meaning you are putting 20% down on your home. It means that you own 20% equity in your home. If you can put down more than 20%, that will give a lower LTV than 80%, which is excellent. It is not unheard of for people with excellent credit to have a 50% LTV.

The higher the down payment towards the purchase, the less risky the loan as the borrower puts “more skin in the game” since they own more of the property. If you have poor credit, you can target a higher down payment, which can help you get approved for a loan.

A borrower putting too low a down payment may need to buy mortgage insurance to cover the lender against potential loss if the borrower can’t pay the loan. Federal loans may not require a substantial down payment.

Cash Reserves

Having readily available cash reserves that can cover six months of your basic living needs when you face emergencies is essential. Bankers want to see you have the ability to pay for six months of mortgage payments and prefer you to have some cash reserves on hand.

Homebuyers can apply for a conventional loan from private lenders or government loans, depending on their circumstances regarding their credit scores, ability to put a down payment, and other criteria.

 Conventional Loans

It may be challenging to qualify for a conventional mortgage if your credit score is below 640. Lenders may require a higher down payment of at least 20% to offset your lower score. Most private lenders will require private mortgage insurance (PMI) when borrowers put less than 20% down on their home loans.

You should continually improve your credit score to get a better interest rate for your loan. It takes time and patience but raising your credit score is possible. If a conventional loan is out of the question, you can either work on improving your score or apply for a government-backed loan. 

Government Loans

For those borrowers with bad credit, you can apply for federal government-backed loans. You may have more flexibility on the credit score and require a lower (or even a zero) down payment. However, each entity may require its respective mortgage insurance (similar to PMI) when down payments are less than 20% of the home value.

Federal Housing Administration or FHA Loans

An FHA loan is one of the more lenient options for buyers with bad credit, may have gone through bankruptcy, foreclosure, or first-time homebuyers who may not have saved a large enough down payment.  Created in 1934, the FHA guidelines for borrowers are:

  • A FICO credit score of at least 580  requires a 3.5% down payment.
  • If your credit score is between 500 and 579, you need a 10% down payment.
  • Borrowers will need to buy a mortgage insurance premium (MIP) if down payments are below 20%.
  • The debt-to-income ratio must be less than 43%.
  • The home has to be the borrower’s primary residence.
  • The borrower must show steady income and proof of employment.

All FHA loans require borrowers to buy a mortgage insurance premium (MIP). This insurance protects lenders from losing money should the borrower default on the loan. Mortgage insurance requires an upfront fee of 1.75% of the original loan amount. There is a recurring monthly fee varying from 0.45% to 1.05% of the loan amount. The fee percentage depends on the size of the loan, down payment, and the number of years financing.

An  Example On The Mortgage Insurance Fee

Let’s say you are buying a $200,000 home, with a 10% down payment of $20,000. Your original loan is $180,000. The upfront mortgage insurance fee of 1.75% x $180,000 is $3,150. You will also have a recurring payment, using the fee of 0.45% to 1.05% of $810 to $1,890 in the first year.

Veteran’s Administration (VA) Loans

VA home loans are non-conventional loans available to veterans, those serving in the military, or eligible surviving spouses seeking to become homeowners. Private lenders are the issuers of the loans, but the VA determines who qualifies for the loans and is the guarantor.

If you are qualified for a loan, there is no minimum credit score, and you may buy a home with no down payment. Although you don’t pay private mortgage insurance, there is an upfront VA loan funding fee of 1.4% to 3.6% of the loan amount if you put less than 5% down payment on your home.

USDA Loans

The USDA loans are for rural borrowers who may qualify for a mortgage directly from the US Department of Agriculture or a USDA-approved lender. The loan has specific home requirements, and its location must be in a qualified rural area.

You may not need a minimum credit score if you are getting the loan directly from the USDA. However, to qualify for such a loan when using a USDA-approved lender, you will need to have a minimum credit score of 640.

You don’t need to put any down payment for the USDA loan. However, like private mortgage insurance for conventional mortgages or MIP for FHA loans, borrowers of USDA loans pay mortgage insurance via two fees. There is an upfront guarantee fee equal to 1% of the loan amount and a recurring fee of 0.35% of the loan.

Home Loans From Fannie Mae And Freddie Mac

Fannie Mae and Freddie Mac were government-sponsored entities, transitioning out of conservatorship. Neither entity originates or services its loans but buys loans from private lenders who require PMI if down payments are less than 20%. Their respective loans are designed for low income first-time or repeat homebuyers with limited cash for down payments:

Fannie Mae HomeReady Mortgage requires a 3% down payment with a 620 minimum credit score. They may use alternative data with a lower score. Borrowers will need private mortgage insurance when putting less than 20% down.

Freddie Mac Home Possible loan requires  3% down with a minimum of a 660 credit score. Without that score, borrowers require a 5% down payment.

Final Thoughts

Before searching to buy a home, you should understand your credit report and score. Consider improving your creditworthiness so you may get a favorable interest rate. If you are still getting your own home, there are several government-backed options for qualifying for a home loan if you have bad credit. 

You will likely be paying higher interest rates than those who have good-to-excellent credit scores. You will have to pay some kind of mortgage insurance if you cannot put a down payment of 20%. As you improve your credit, consider refinancing your loan.

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