You’ve probably heard by now that you need great credit to secure a mortgage. After the housing crisis, this is not far from the truth. Lenders got much stricter with their requirements for fear of being penalized or being forced to buy loans back from the secondary market. The Dodd-Frank Act and the Ability to Repay Rule also help to limit the loans lenders can hand out. However, there are ways to buy a home with bad credit, as long as you have good income and can explain the bad credit away. Your chances of approval are even better if you have drastically improved your credit history, but your score has not quite yet increased. Either way, prepare yourself for a long road ahead.
What is Bad Credit?
The answer to this is relative. What one lender considers “bad credit,” another might not have a problem with and vice versa. Generally speaking, a truly bad credit score is one that is below 500. However, most lenders tend to look at any score below 660 as not high enough to qualify for a home loan. There are exceptions to the rule, especially when there are legitimate reasons in place, but anything below 660 is often looked upon with great scrutiny.
What is the Reason for the Bad Credit?
The first thing lenders want to know is why you have bad credit? Did you lose your job for reasons outside of your control? Or did you get in over your head? Maybe you charged too much and couldn’t keep up with the minimum payments any longer. Maybe you have a foreclosure or bankruptcy in your past that affects your credit score. Whatever the case may be, you have to provide reasons for the bad credit. These reasons will help to determine just how long you have to wait to secure a mortgage. For example, if you have a bankruptcy or foreclosure, you have to wait out the minimum time period the governing agencies require. Typically, this means at least 2 years. On the other hand, if your credit is blemished with the occasional late payment, you can probably work around it and secure a mortgage much sooner than 2 years.
FHA Loans are a Good Option
If you do have bad credit, the FHA program might be a good option for you. Their general requirements are more flexible than conforming loan requirements. You can have a lower credit score, higher debt ratio, and fewer assets and still qualify for the loan. In fact, you can have a credit score as low as 580 and still qualify for the FHA program with just 3.5% down. If you have a score lower than 580, but higher than 500, you may still qualify, however, you must put at least 10% down on the home. This is according to the FHA, though. You have to find an individual lender willing to take the risk on a credit score as low as 580 or 500, depending on your situation.
Subprime Loans are a Good Option Too
Another good option is the subprime loan. You might not find them called by this name very often any longer, though. Instead, you may hear “alternative documentation loan,” “non-conforming loan,” or “portfolio loan,” to name a few. Basically, these loans do not have to abide by the Dodd-Frank Act rules or the Ability to Repay Rule. The reason for these exceptions is the lender keeps the loan on their own books. They do not sell it in the secondary market. This is where the strict rules come into play because the government wants to protect investors from the landslide they experienced during the housing crisis. If a lender keeps the loans on its own portfolio, though, they can take the risks they are willing to take.
Compensating Factors Help Buy a Home With Bad Credit
No matter what situation you have on your hands, most lenders will be more willing to help you buy a home with bad credit if you have compensating factors. If you have good income and/or a good job, this is a great place to start. You show the lender that you have the financial resources to pay the mortgage. However, they may want to see other compensating factors as well. A few examples include:
- Little to no payment shock – If you currently rent and the rent payment is as high or close to the intended mortgage payment, you have very little payment shock. If, on the other hand, your rent is low, say $800 and your potential mortgage payment will be $1800, this may be too much of a payment shock for a lender to approve you for the loan.
- A large down payment – The more money you put down on the home, the lower the risk to the lender. When you invest your own money, you are more likely to do what you can to pay the mortgage and avoid foreclosure. On the other hand, if you only invest 3% or so, there is not a lot of incentive for you to continue to make payments when you experience a hardship.
- Good explanation for bad credit – Lenders know that life happens and sometimes what happens is outside of your control. If you suffered a bankruptcy as a result of an injury or illness that prevented you from working, this could be considered a one-time occurrence. If you can show that you picked up the pieces and are successfully moving forward, the lender may be able to overlook your “bad” credit score for qualifying purposes.
- Low debt ratio – The fewer debts you have to cover in addition to your new mortgage payment, the better you look to a lender. Each loan program has specific debt ratio guidelines, but if you can come in with a debt ratio significantly lower than the stated guidelines, you may have a better chance at the lender overlooking your bad credit.
The bottom line is that you can buy a home with bad credit. You just have to know where to look and what the lender wants to see. When you get all of your ducks in a row and present an opportunity to provide you with a loan with little risk, the lender may be more willing to overlook your credit score. It is not the only thing they evaluate, but it can play an important role, so being prepared as possible will help your chances in the end.