Bad Credit Home Loans: A Guide
Point of Interest
Even if you have bad credit, homeownership might still be an option, but your interest rates will be higher than average. Compare quotes from multiple lenders and carefully consider other options.
Owning a home is a financial dream most people hope to achieve at some point in their lifetime. You’ll be able to stop paying rent and have your funds go toward something you own instead. But if you’re trying to buy a home with bad credit, it can be a challenging process with many obstacles. Don’t let loan rejections due to poor credit deter you from making your homeownership dreams a reality.
Thankfully, there are a few mortgage options for individuals who need a bad credit mortgage, but to take advantage of these options, you’ll need to know how to buy a house with bad credit and how to work with bad credit mortgage lenders.
Credit Requirements for Buying a Home
When you apply for a mortgage — or any loan for that matter — lenders will take a look at a number of factors to see if you’re a reliable borrower.
First, lenders will pull your credit report to check your credit score and look at how many open accounts you have on your credit. In general, borrowers with a credit score of 750 or above have the lowest chance of getting rejected for a mortgage and may qualify for the lowest possible rate a lender offers. If you have a credit score lower than 650, it can be difficult for a lender to offer you the lowest available rate or even approve you for the loan at all.
A lender will also look at your debt-to-income ratio. This ratio will show them how much money you make compared to how much you have in debt payments each month. It is typically calculated with your debt divided by income.
Challenges of Buying a Home with Bad Credit
Buying a home with poor credit comes with a set of unique challenges. If you have a lower credit score, you most likely won’t qualify for the lowest interest rate possible, which means that you’ll be handing over more money each month toward your payment and paying more in interest on your mortgage over time.
For example, if you qualified for a lower rate and borrowed $200,000 at a fixed rate of 3.99% for 30 years, your estimated monthly payment is $1,115.
Let’s say you qualify for a much higher interest rate of 6.0% due to your credit, though. This would result in your monthly payment being $1,312 per month. That’s $197 more than if you had qualified for a lower rate. Even though the difference of the interest rates is 2.01%, it adds up to more than $70,000 paid over the life of the loan on interest alone.
This calculation assumes a 20% down payment. If you do not have the ideal 20% to put down on a mortgage and your credit is less than stellar, it can cause further issues. For example, there are home programs that allow for as little as 3.5% down on a home, but there are credit requirements associated with them. If you do not meet the credit requirements, you’ll have to provide a larger down payment up front and may even have to pay a higher private mortgage insurance (PMI) premium due to being a higher-risk borrower.
Home-buying Options for Bad Credit
An FHA loan is funded through a private lender, but it is insured by the Federal Housing Administration, which allows for lower credit requirements to get approved for the program. If you have a credit score of 580 or above, you may qualify to put 3.5% down on your home, or 10% down if you have below a 580. It is up to the lender to determine your interest rate based on their qualifying factors. You also must have a debt-to-income ratio of less than 43%, or else you’ll be rejected.
USDA loans are for individuals who want to buy affordable housing in rural areas across the nation. This loan is also provided through a private lender but is backed by the United States Department of Agriculture. You may qualify for a mortgage without a down payment with a credit score of at least 620. Having at least 20% for a down payment can earn you a better interest rate, though — which is similar to conventional home loans.
A VA loan is a great option for active military members and veterans. Backed by the Veterans Association, borrowers aren’t required to have a down payment and also aren’t required to pay PMI, even if they don’t have a down payment. Credit requirements are up to the lender, though, because the VA does not have minimum requirements for the program.
How to Improve Your Credit Score Before Buying a House
Before taking out a mortgage with bad credit, you should consider whether it makes sense to improve your credit first.
Start by pulling your credit report from Equifax, TransUnion and Experian. You are able to get one free credit report each year. This will give you an idea of where you stand on your credit report. Check for any inaccuracies and be sure to dispute anything that is showing incorrectly on your report.
Once you check out your official report, begin paying off debt balances. Credit utilization counts for more than 20% of your credit score, which is the percentage of your available credit you’ve used across all credit lines, including credit cards and lines of credit. The higher your credit utilization is, the more it negatively affects your score. It is recommended that you keep your credit utilization less than 30%, and your score will increase even more if you can get it below 10%.
If you are unsure of how to handle your credit on your own, you may consider hiring a credit repair company like Lexington Law. These companies offer to meticulously look over your credit and attempt to take care of any blemishes that are there. Be cautious of these companies, though, as they usually charge a hefty fee for their services. You may want to consider credit counseling first or speaking with a representative at your home bank or credit union before you pay a credit repair company.
Pros and Cons of Buying with Bad Credit
The biggest benefit to these options is that it allows individuals with poor credit to still make their homeownership dreams come true. Borrowers don’t have to let their credit history dictate whether or not they can purchase a home. Beware of the downfalls of buying a home with bad credit. You may end up with a higher interest rate, higher monthly payments and PMI premiums that can end up costing you much more over time. Sometimes the solution is to work on improving your credit score before starting your home buying journey.