FHA, VA and Other Home Loans for Bad Credit Borrowers
Bad Credit Home Loans
If you have bad credit or a low credit score, it's often harder to qualify for a mortgage. Products include FHA, VA, non-prime, "hard money" and other loans can make homeownership possible.
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.
Who Needs Bad Credit Home Loans?
How do you know if you need a bad credit mortgage? You might need some underwriting flexibility if any of these conditions apply to you:
- You have a FICO score under 620.
- Your debt-to-income ratio (DTI) exceeds 43 percent.
- Your down payment is less than 5 percent.
- You’ve been through a severe credit event like a bankruptcy or foreclosure recently, even if your credit score exceeds 620.
- Your income is difficult to prove or does not qualify under traditional mortgage guidelines.
- You’re flipping homes and need fast cash for investment.
Note that one of the above-listed conditions might not put you into non-prime mortgage territory. However, a combination of factors, for example a small down payment, low credit score and high DTI could easily do so. Mortgage lenders refer to this as layering of risk.
The easiest way to find out if you need a bad credit mortgage is to apply for a good credit (aka prime) mortgage. Contact one or more mortgage lenders and complete an application online, in person or over the phone. Nearly all traditional mortgage lenders submit your application to an automated underwriting system, or AUS. The beauty of an AUS is that it renders an underwriting decision in just a few minutes.
If you get a loan approval, congratulations. You don’t need a mortgage for bad credit. If your application is declined by the software, you’ll still get valuable information - the reason(s) you could not be approved.
Mortgages for Borrowers With Bad Credit
If you can’t get approved immediately for a prime mortgage, you can look to the products listed below for underwriting flexibility.
FHA Home Loans
FHA home loans are available to anyone who qualifies - there is no income-related eligibility. However, these loans can only be used to buy low- to moderate-priced homes. The FHA sets loan amount limits according to home prices in the area. You may be able to qualify for FHA financing with 3.5 percent down if your credit score is 580 or higher, or a loan with 10 percent down if your credit score is 500 to 579.
However, most applicants who get approved for FHA home loans have much higher credit scores. Your chances of approval are better if your recent credit history is good or if your low score is due to insufficient credit rather than bad credit. You may be able to change a declined application to an approved application by making a larger down payment or paying off debt to improve your debt-to-income ratio.
VA Home Loans
VA home loans are available only to eligible servicemembers, veterans and in some cases their family members. While the VA does not specify a minimum credit score, many lenders that make these loans do set minimums. As with FHA financing, you have a better chance of securing loan approval if your recent credit history is positive, and if you’re not layering risk.
The sub-prime mortgages of yesterday are gone and won’t return under current mortgage law. Lenders can’t originate loans to people with unverifiable income, bad credit and little-to-nothing down. But so-called “non-prime” lenders have stepped in to finance applicants who just missed qualifying for mortgages under traditional guidelines.
Non-prime mortgage lenders can set their own guidelines, so rules and costs vary widely among programs. Here are some features of non-prime programs offered today:
- Bank statement loans to prove self-employment income.
- Co-signers allowed for FICO scores as low as 500.
- One day post-bankruptcy or post-foreclosure loans.
- Financing for borrowers with FICOs down to 550.
The major difference between non-prime home loans and government-backed programs like FHA and VA is the size of the required down payment. Most non-prime programs require a minimum of 15 percent down for their best applicants and as much as 25 percent for higher-risk borrowers. The other difference is that non-prime lenders don’t require mortgage insurance. Interest rates are higher than those of prime or government-backed home loans. For this reason, it’s more important to shop for the best rate and costs for which you qualify. Don’t just jump on the first loan approval you receive without comparing other offers.
“Hard money” or private financing doesn’t come from licensed mortgage lenders. Instead it’s offered by private individuals or groups of investors. Hard money loans have some common characteristics:
- Higher upfront costs - it’s normal to pay several points upfront.
- Shorter terms - you may only get a year or two to get your credit in order and qualify to refinance your loan.
- High down payment requirements - 25 percent or higher is common because these lenders assume that the loan won’t be repaid and that they will have to foreclose.
Interest rates for hard money loans can approach 20 percent. That may be okay if you plan to fix and flip a property in a month or two and that the profit will exceed the financing and rehab costs. Many investors who use these loans don’t have bad credit at all. They just want fast financing without too much red tape.
Buying a Home With Bad Credit: Here’s Your Plan
Don’t automatically assume that you need a mortgage for people with bad credit. Or that buying a home with expensive hard money or a non-prime loan is your best decision. Take these steps and create a plan to increase your chance of successful homeownership, even if you have credit problems.
- Check your credit report and score.
- Determine if your report is accurate, and correct errors.
- If you’re VA-eligible, apply for a VA home loan.
- Otherwise, apply for an FHA home loan.
- If your first application is denied, get the reason(s) for denial from your lender. That’s your roadmap to getting approved for a home loan.
- Depending on your reasons for denial, you’ll either reapply with a different lender, apply for non-prime or hard money financing, or fix your finances before applying at a future date.
How do you know if you should reapply with a different lender? You should try again for a government-backed loan if the reason for denial is a “lender overlay.” Lender overlays are underwriting guidelines that are stricter than the program requires. For example, the FHA allows loan approval with a credit score as low as 580. But your lender might set its minimum at 640. If your FICO score is, say, 620, and your credit report shows 12 months of paying as agreed and no new derogatory entries, you might succeed with another lender.
How do you know if you should apply with a non-prime or hard money lender? These loans can be much more expensive, and with their higher interest rates and payments, you are at greater risk for missing payments or ending up in foreclosure. If your DTI is higher than 43 percent, reconsider buying a home and work on shoring up your finances and your credit rating. One of the biggest reasons people lose their homes is taking on a payment that they cannot afford.
When Should You Postpone Buying a Home?
Sometimes buying with a bad credit home loan is not the best idea. If you “just missed” qualifying for a government-backed mortgage, taking a few weeks or months to improve your credit and finances might save you a lot of money and get you on the track to better credit and improved financial security.
Here are a few things you can do to improve your prospects for homeownership:
Make your payments on time every month. Set up automatic payments if this is a challenge for you. You need about a year of good payment history to qualify for a government-backed loan.
“Practice” for homeownership. Run the numbers and see what your monthly home costs would be, including mortgage principal and interest, property taxes, mortgage insurance, homeowners insurance, HOA dues (if applicable), and routine maintenance charges. Subtract your current rent from this amount - the difference is how much more you’ll be spending every month when you buy a home. Take that amount and put it into savings every month. You’ll determine if you can live with the reduction in discretionary income, and you’ll improve your finances with increased savings.
A good mortgage professional can run different scenarios through automated underwriting and see which combination will get you approved - a higher down payment, for instance, or paying off some debt, or increasing your reserves (emergency savings). Then stick with your plan until you achieve that winning profile.
Monitor your credit with a free application or by pulling a free credit report every three months at the government’s site, annualcreditreport.com.
Whether you buy a home now or shore up your finances first, a good payment history on your next mortgage will help increase your credit score and help you qualify for a prime mortgage in the future.
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