Simply put, if you need a mortgage to buy a home and you have bad or even no credit, it’s going to be a challenge. Don’t despair; there are mortgage programs to serve consumers that have less than ideal credit.
Why do Mortgage Lenders Care About Your Credit?
One of the primary uses of a credit file (your credit report) or credit score as its more commonly referred to, is to give potential creditors an idea of how much credit you have utilized, how much is available to use and most importantly, how you have handled your debt related obligations. Understanding your credit history and behaviors is one way that creditors predict how you may handle your future obligations. In other words, your credit history and score helps a lender to measure the level of risk associated with the loan they are considering making you. The lender assesses this risk and decides whether to extend credit to you at all, and at what terms.
The good news: you can get a mortgage with bad credit.
The bad news: you’ll almost certainly pay more than a borrower with better credit.
What is bad credit?
While the credit scoring formula calculates your score it does not make the decision on whether to lend to you or not. There is a general definition on a bad to excellent score. Each lender, however, applies their own lending standards to the scores, which may look something like this:
720 and up – Excellent
680-720 – Good
620-680 – Fair
580-620 – Poor
Below 580 – Bad
It is important to understand that while your credit score is a very important factor in a lender’s decision to approve a mortgage loan, it’s not the only one. Even a consumer with a 750 credit score who may also have, for example, a very high level debt, may not be approved for a mortgage loan. It is also important to understand that having no credit or an insufficient credit file is different than bad credit. With a thin file or no file, which makes you unscoreable, many lenders can use alternative credit (your cell phone or utility payment history, rent payment history, etc.) to determine if they can approve you for a mortgage loan.
What are the mortgage options for someone with bad credit?
When you apply for a mortgage, the lender will evaluate your entire financial picture. If you can make a strong showing in other areas of the application, your bad credit may be offset by these other factors. Let’s explore some of those other areas.
Save a Larger Down Payment
The most challenging mortgage applicant is one who has both bad credit and no cash to contribute towards the purchase of the home. If you have one or the other – a decent credit score or enough money for a modest down payment – your loan options open up.
A down payment makes you a less risky borrower. When you’ve got a stake in the property and the lender’s financial exposure is reduced, the loan is easier to qualify for, even if you have challenging credit.
Any amount you can save will help you. Don’t obsess about 20% down. Most U.S. homebuyers get into mortgages with far less (an average of 11% in 2016, in fact). If you can save up 3% or 5%, you’ll find plenty of lenders willing to talk to you about a loan.
If you can save up 20%, your wallet will thank you. First, your monthly payment will be smaller because you’ll borrow less. Second, you’ll save on private mortgage insurance. That’s an extra fee that most lenders require from borrowers who have less than 20% equity in the home. If you take an FHA loan, you’ll pay this insurance premium every month for the entire life of the loan, even as your equity rises.
Lower Your Debt-to-Income Ratio
A high debt-to-income (DTI) ratio is perhaps the biggest mortgage application red flag. A 2014 survey of lenders found that high DTI was the number one reason loan officers decline mortgage applications (it’s even more important than credit score).
Your DTI is a measure of affordability. The lender needs to make sure you’re not getting into an unfordable loan, one that leaves you without enough money to live.
DTI is measured two ways. Front end DTI is your total housing expense (mortgage, taxes, insurance and HOA fees if any) divided by your total gross income. Back end DTI is your total debt obligation (housing expense plus any credit card minimum payments, car loan payments, judgments or other outstanding debts) divided by your total income. DTI limits are generally 31%, front end and 43% back end.
For example, if you and your spouse earn $4,000 per month before taxes, 31%, the front end ratio, is $1,240.00 which would be the maximum housing expense the lender would approve you for. The back end ratio at 43%, of your total debt obligation, which would include the house payment, cannot exceed $1,720 per month.
Apply with a co-applicant
You may have an easier time qualifying for a mortgage if you apply with another person. The co-applicant can’t negate your bad credit (generally the terms are based on the credit score that is lower), but he or she might help you get on stronger financial footing and stay under the DTI limits (assuming the co-applicant has income without a large amount of debt).
For some loans, including the FHA program, the co-applicant does not need to live with you.
Mortgages for Bad Credit
Mortgage options are more limited for borrowers with bad credit, but they do exist. Here are a few examples.
If you can’t get approved by a lender, the seller may be willing to finance your purchase of the home. This is sometimes referred to as the seller “carrying the papers,” “taking back a mortgage,” or “holding the paper.” Institutional private lenders can also be found online.
FHA loans are made by lenders and insured by the Federal Housing Administration. The most popular FHA loan requires a credit score of at least 580 and a down payment of 3.5%.
USDA loans are made by lenders and insured by the U.S. Department of Agriculture. The applicant may not earn more than 115% of the median income for the area, and the property must be located in an eligible rural or suburban area. No minimum credit score is required for a USDA loan.
Freddie Mac offers the Home Possible mortgage loan program to low and moderate income buyers in high cost and underserved communities. Applicants with no credit score are eligible with a 5% down payment.
Getting Ready for a Mortgage
You can achieve your goal to buy a home.
Begin by addressing your credit issues. Take advantage of free credit counseling by HUD approved agencies. Homebuyer education workshops are also available both in person and online. Costs vary and many are free. You can also sign up for homebuyer pre-purchase counseling (and some loan programs require it) for help identifying your financial priorities are and establishing a financial roadmap to achieve your goals.
Get copies of your credit reports from all three credit bureaus to become familiar with the data they contain. Take a free class on understanding your credit report. Review your reports for accuracy and dispute any discrepancies. Credit and housing counseling agencies have certified coaches that can help you to better understand your credit profile and help you develop tangible strategies to improve your situation.
Check your credit score on one or more of the many free credit score websites that exist, or perhaps by logging into your bank or credit card issuer’s website.
The best way to fix or improve your credit will depend on the factors unique to your credit history. Many U.S. consumers with bad credit struggle with high debt. One of the best things you can do for yourself is to start paying it down.
Other negative factors include collections (make a plan to pay them off), bankruptcy or foreclosure (their effect on your score will diminish over time), or lack of credit accounts (open a secured card to start building a credit history).
Your credit standing can improve very quickly. For example, if you pay off a credit card balance, you might see a better score within a month. Establish a perfect payment history and work to keep debt low, and your score will improve steadily over time.
Getting a mortgage with bad credit is not impossible, but it is more costly. Any efforts you make now to improve your standing could pay off in real savings if you’re able to get better loan terms when you’re ready to buy.