How to Buy a Home with Bad Credit
Bad credit can seem like an impossible obstacle on the road to buying a home. But with the right preparation or loan, a low credit score doesn’t have to stop you from reaching your final destination: home.
As long as your credit score is above 500, there’s probably a loan option that will work for you. If your score is on the lower end, you’ll fare better with a government backed loan and a larger down payment.
Regardless of your credit score, you’ll also need to be able to prove to the lender that you have a reliable income and have been paying your bills on time for at least a year or two.
Let’s take a look at the types of home loans available to those with low credit scores, as well as what the home loan process might entail.
- What is Considered Bad Credit
- Types of Loans for Low Credit
- Other Factors Lenders Will Consider if You Have Bad Credit
- What to Expect If You Have Bad Credit
- How to Improve Your Credit Score
What is Considered Bad Credit?
There’s no hard and fast definition of “bad credit.” Instead, the phrase refers to a low-ish credit score, usually below 670. Experian, one of the three credit bureaus, defines scores of 300–579 as poor and scores of 580–669 as fair. If your credit score is above 500, your mortgage lender will probably work with you to find the right loan. If your score is below 500, it’s likely that you’ll need to work on raising your credit score before applying for a mortgage.
Types of Loans for Low Credit
Credit Score 500–579: FHA Loan
FHA loans, which are backed by the Federal Housing Administration, are a great option for first-time homebuyers, especially those with a low credit score. If your score falls within this range, you’ll need to contribute a hefty down payment of at least 10 percent. Because the government is investing in you as a riskier mortgage client, there will be additional requirements. For example, you’ll need to pay off any other collections and judgments that are outstanding, and the home will have to be your primary residence.
Credit Score 580-619: FHA or VA Loan
Once your score gets closer to 600, your loan options will widen and the requirements won’t be so strict. With a credit score in this range, you can also apply for an FHA loan with a smaller down payment, in some cases as low as 3.5 percent.
If you’re a veteran or active-duty service member, you should definitely consider a VA loan. These loans, which are backed by the Department of Veterans Affairs, require no down payment. Most lenders will require a credit score in the low 600s for a VA loan; Dash requires a 580 credit score.
Credit Score 620–699: Conventional Loan or FHA Loan
If your credit score is in this range, you may qualify for an FHA or Conventional loan with a lower or no down payment. An FHA loan will likely be the most attractive (from a cost perspective) if your score is near the lower end of the 620-699 range. As your score gets closer to 700, a Conventional loan will be more attractive (from a cost perspective). Conventional loans typically require down payments of at least 5 percent.
Additionally, if you’re looking to buy a home in a rural area with this kind of credit score, you might qualify for a USDA loan. These loans are backed by the U.S. Department of Agriculture and don’t require a down payment.
Other Factors Lenders Will Consider if You Have Bad Credit
While you may qualify for the loans above with the credit scores described, there are other factors that may affect your lender’s decision, for better or for worse. Other factors lenders will consider include:
How Much You Have Available for a Down Payment
The larger down payment you have, the better. That’s because your low credit score will probably impact the amount of your mortgage loan (you’ll qualify for less), and a larger down payment can help make up the difference if you’re considering a more expensive house.
How Much Debt You Have and How Much Credit You’re Using
Consider your debt like a pie chart: The more of that chart that’s filled with debt pie, the less space there is for new debt pie—like your mortgage. So the less debt you have and the less credit you’re using, the more loan you’ll qualify for.
How Much Income You Have Coming In
Even if your credit score was great, this would still be an important factor. Your lender wants to ensure you have enough money coming in every month to pay your mortgage.
If You Have Any Debt in Collections
Collections show up on your credit report and indicate to lenders that you have an outstanding, overdue debt which you haven’t tried to pay. That’s a signal of an unreliable lendee, and the lender will be less likely to lend you more money.
What to Expect If You Have Bad Credit
While you might be able to qualify for a loan, there will be some cons to moving forward with a mortgage with a low credit score which you should know about.
Be Prepared for a Larger Down Payment
Most of the loans you’ll qualify for with a low credit score do require a larger down payment. In addition to helping you make up the difference on a small mortgage, a larger down payment will probably simply help you to qualify for a better loan. It shows the lender that you’re serious and capable of saving money. Plus, if you can put down 20 percent or more, you’ll avoid PMI, or private mortgage insurance. PMI is designed to outweigh the risk the lender takes on in offering you a mortgage, but with enough money down, you basically eliminate that risk.
Be Prepared for Higher Interest Rates
When lenders agree to offer a mortgage to someone with a low credit score, they recognize they’re taking on a risk. To make up for that risk, they’ll usually charge a higher interest rate, up to 5 percent instead of 3 percent. It might not sound like a lot, but over the course of a normal mortgage term—anywhere from 15 to 30 years—that extra interest can add up to thousands of dollars.
How to Improve Your Credit Score
While there are ways to navigate the pothole of a low credit score, the best option is to raise your credit score (and, if your score is below 500, it’s probably your only option). If raising your credit score feels intimidating, it shouldn’t. There are steps you can take to immediately raise your score, as well as others that can make a big difference over time.
Check Your Credit Reports for Errors
It can feel overwhelming to even consider the details of your credit report, but it’s worth checking. Look for anything that doesn’t seem accurate—that could be a payment that hasn’t been updated, an outstanding loan that you don’t know about, or an incorrect balance. If anything seems off, contact the credit bureau or creditor to dispute it. Your diligence could immediately remove the error and improve your score.
Pay for Deletions
If you notice anything that’s in collections, you should pay it immediately because these make you look like an irresponsible lendee. Once it’s paid, it will still show up on your credit report as paid, which is definitely a step in the right direction. However, you can also ask (and pay) to have it deleted from your credit report. Just make sure you have it in writing from your lender that they’ll delete any history of your collection. This, too, could instantly boost your score.
Avoid Hard Credit Checks
There are soft checks—like applying for insurance—as well as hard inquiries into your credit. Hard credit checks occur when you apply for a new account, and if you have a lot of these hard checks in a short period of time, it could negatively affect your credit score. That’s because asking for multiple lines of credit in a short period of time can look desperate to lenders, making you seem like a risky client.
Increase Your Credit Availability
A good credit score is determined, in part, by the amount of credit you’re using. If you have a credit card limit of $1,000, for example, and you’re using more than 30 percent of that limit (more than $300), it could negatively impact your credit score. The easiest way to increase your credit availability, of course, is to pay off more of your debt. However, another way is to increase the limits on your credit cards. All you have to do is call your lender and ask for a credit increase. Increasing your credit only requires a soft credit check, so it won’t impact your credit score. Your final option is to open new accounts, which will increase your credit availability but will require a hard credit inquiry.
Be a Good Steward of Your Debt
This is the long game for good credit. Increasing and maintaining your credit score requires that you make your payments on time, utilize 30 percent or less of your available credit, maintain your accounts over long periods of time, and never let loans go into collections. The best thing you can do to increase your credit score? Pay off your debt. It takes time, but your credit score will be a credit to your efforts!
Bad Credit, Good Mortgage
Whether you decide to hold off on buying a home until you improve your credit or move forward with a less-than-stellar credit score, you have options. There are loans available and designed to help people with imperfect credit histories purchase a home. If that sounds like you, we at Dash would love to talk through your options and help you decide if now is a good time to buy a home.
Opinions expressed are solely my own and do not express the views of my employer.