Is This Guide for You?
Do any of the below financial problems apply to your personal circumstances? If so, this guide can help you get a few steps closer to homeownership.
Approval Factors for Bad Credit Home Loans
To lend or not to lend ... that is the question potential lenders weigh when reviewing loan applications, especially those of borrowers with bad credit. Whether you're seeking a government-backed or conventional loan, many factors will determine your chances for approval.
Arthur Brown, a 24-year mortgage industry veteran based in Denver who has worked as a senior mortgage consultant, says that information is used to gauge your likeliness and ability to repay a loan. For example, any credit score below 620 is typically considered bad credit in the mortgage-lending industry, he says. If you're at or below this level, you may want to delay homeownership and work to improve your score in order to access better rates.
"Technically a credit score of 580 or higher will put you in the ballpark for buying a home, but you will have much fewer options," says Brown, who is now a branch manager for Fairway Independent Mortgage. Below is a look at the factors that can make or break a loan approval.
Your FICO score is critical. This number — generally between 300 and 850 — helps lenders assess you as a loan risk and determine your creditworthiness. A higher credit score, (typically 740 and above) qualifies you for the best mortgage rates and terms. Anything below 580 is considered bad, or subprime, credit, and usually correlates to higher interest rates. Adding a cosigner won't address the credit issues, Brown says, because your name is still on the loan. "It only helps with meeting the income requirements needed to qualify."
Paying down outstanding debts will help raise your credit score, especially older debt. Be sure not to run up any new debts in the process. Mortgage lenders look closely at your debt amounts and ages. "So that cable bill from college that you refuse to pay is killing your score," says Atlanta-based credit expert and financial consultant Rob Wilson. Lenders also look at the payment histories on your different credit lines. As a subprime home loan seeker, you should avoid opening up new accounts and running up balances that aren't paid off.
Your credit utilization ratio — the ratio of credit debt you incur in relation to your credit limits — can dramatically lower your FICO score. Experts advise keeping your utilization at no more than 35 percent to help qualify for the best loan terms and rates. Charging too much on cards or maxing them out will cause potential lenders to view you as high risk. Low utilization helps convey that you can manage your credit well.
While your FICO score is considered a good indicator of how well you pay your bills, your DTI is an even bigger factor for lenders considering subprime mortgages. It helps them determine how much you can comfortably afford to borrow. DTI ratios are not one size fits all, but lending experts generally advise keeping your DTI at or below 36 percent when factoring in all of your monthly expenses.
Having filed for bankruptcy or a foreclosure in recent years doesn't necessarily mean that you can't qualify for a loan, as long as you meet other requirements, such as reestablishment of good credit and a consistent payment history. Brown says that with a Chapter 7 bankruptcy, you can't qualify for a home loan until two years from the discharge date, as long as you've reestablished credit. On a Chapter 13 bankruptcy, you can qualify as soon as the terms of the 3 to 5-year payment terms are met. "So, if you got discharged on a Tuesday, technically you can qualify on a Wednesday," says Brown. Following a foreclosure, it generally takes 2-3 years to qualify, if you meet income requirements.
Less is not more in terms of credit history when trying to buy a home. In many ways, having no credit makes potential lenders just as skittish as bad credit because there's no history to review. Building up a positive credit profile that conveys your creditworthiness will help.
It's critical that you are able to demonstrate consistent income. FHA loans require a steady employment history of at least two years — even better if it's with the same company, which conveys stability. If you have a new job, most lenders want to see that you've at least remained in the same industry. They also review your salary amount and whether you've received raises. Potential lenders may request explanations in writing for any job changes or employment gaps of longer than a month. If you're self-employed, you may still be able to qualify.
How to Qualify for a Subprime Mortgage
Even with bad credit, you can take steps to get approved for a home loan. Take your time, do your homework and keep your eyes on the prize.
Review Your Credit Reports
It's quite common for credit reports to contain mistakes, so review yours closely to catch any errors and begin working to correct them at least a month before applying for a mortgage. Plus, it'll save you a lot of time and frustration at closing. "A lender will not let you close on a mortgage if there's a dispute on your credit report, so you'll want to get that cleared up as soon as possible" Brown says. While you can't directly remove anything from your report, you can dispute inaccuracies and incomplete data, including outdated information, incorrect payment statuses and credit records that aren't yours. For more information, see our guide on how to review our credit.
Evaluate Your Credit Score
The criteria for conventional loans are usually too stringent for those seeking bad credit home loans; an FHA loan is typically more attainable. A minimum FICO score of 580 is required to qualify for the 3.5 percent down payment option, and new borrowers with scores lower than 580 may be required to put at least 10 percent down. Each of the three major credit-monitoring agencies generates a score, and lenders tend to use the middle score. Check out our guide on getting a free credit score.
Create Positive Credit Info
Using credit responsibly helps make you more attractive to mortgage lenders. Paying your debts on time, paying off or down credit cards and always paying more than the monthly minimum all help boost your credit score. "If nothing else, pay your bills on time," advises Wilson, who is author of the book "W.I.N.: Wealth Increasing Now." "Delinquent payments are (credit) score killers." The key is keeping your balances below 35 percent of their limits. For more ideas on how to build positive credit and improve your credit score, check out our ultimate credit score guide.
Save for a 20 Percent Down Payment
While it's possible to get a mortgage with a smaller out-of-pocket cost, you may improve your chances of getting approved by making a larger down payment. Putting down 20 percent or more can provide a potential lender with the needed assurance that you'll pay the loan back. Also, putting down more can end up saving you money in the long run by lowering your monthly payment and even protecting you from interest rate and home price hikes.
Look at Government-Backed Loans
Although you may have to pay a higher interest rate or save for a larger down payment, it is possible to buy a home with bad credit, especially if you tap into federal and local resources, including FHA loans. "You should contact the community development office in your city or county for information," Wilson says. "There are a lot of great programs out there, and many have counselors available to help walk you through the process. You don't have to do it alone."
Next Steps for Borrowers Seeking Home Loans for Bad Credit
Still not sure where to start? Check out the MoneyGeek guides below for further help on your homebuying journey.
As a potential homebuyer, it's crucial to learn your debt-to-income ratio. You can calculate your debt-to-income ratio with a simple formula: divide your total recurring debt by your gross income, or by simply using MoneyGeek's DTI calculator. Your debt should include all of your monthly debt obligations — or recurring debt — including the principal, interest, taxes and insurance on any loans, along with monthly credit card payments and any other expenses you have.
The saying goes that knowledge is power, and the same goes for homebuying. The information you learn at a homebuyer counseling session or seminar can save you time and money and help you decide on the best course of action for addressing your specific homebuying needs. "Start by Googling 'down payment assistance programs near me,'" suggests Brown. The Department of Housing and Urban Development (HUD) sponsors housing counseling agencies throughout the country that provide free or low-cost advice. Help is also available through your local community affairs office and at FHA.gov. Learn how to get help from a housing counselor.
As a borrower with a low credit score, you may be required to come up with a 10 percent down payment to qualify for an FHA loan. Fortunately, you'll find a plethora of assistance programs, many of which offer competitive interest rates and lower down payments. All programs have special criteria that must be met in order to qualify, so you should review those requirements closely before signing up. Check out MoneyGeek's guide on homeownership assistance.
Before embarking on a home search, you should budget for all the costs involved — from your down payment to closing costs. Even if you qualify for more, you should take the time to determine what you can comfortably pay for a mortgage each month. Start by writing out a budget that factors in your income and monthly expenses, such as insurance, auto costs, utilities, groceries and even entertainment. Ideally, your mortgage shouldn't exceed 28 percent of your monthly income. Read MoneyGeek's budgeting guide.
FHA loans are government-insured loans backed by the Federal Housing Administration. Private lenders fund these loans, but the requirements are typically more lenient than most conventional programs. Because of their lower down payment requirement — 3.5 percent in most cases — government backing and the ability to qualify with a higher total monthly debt amount, FHA loans tend to be a great option for bad credit borrowers. FHA loans also offer the same interest rate for all borrowers, regardless of credit issues, but there are minimum credit score requirements. Learn more about FHA loans.
The Department of Veterans Affairs (VA) loan program is one of the best home loan options available for many veterans, service members and military families, especially for those who might otherwise struggle to secure financing. There are several benefits associated with these government-backed loans, including no down payment or private mortgage insurance (PMI) requirements, flexible terms and competitive interest rates. The loan is assumable, and you are eligible for a streamlined refinance if rates go down. The credit score requirements also are less strict than most conventional loans.
USDA loans are mortgages for homes in rural areas and are backed by the United States Department of Agriculture. Among the many benefits are 100 percent financing, no down payment requirement and below-market mortgage rates for those who qualify. A good to average credit history is required. Check the USDA website to determine whether you might be able to qualify for this loan in your area. Read MoneyGeek's guide on USDA loans.