Having bad credit can make buying a home seem impossible, but it’s not. In fact, there are programs, and even lenders, that specialize in home loans for people with bad credit.
Written by Attorney Aan Malahia Chaudhry.
Updated October 18, 2021
Having bad credit can make buying a home seem impossible, but it’s not. In fact, there are programs, and even lenders, that specialize in home loans for people with bad credit. And there are many things you can do both before and during the home-buying process that will make it easier for you to qualify for more loans and get competitive interest rates.
Know Your Credit Score and Credit Report
A credit report is a statement that breaks down your credit history. Your lender will review this important document when you apply for a mortgage. Being familiar with your report will give you a good idea of what mortgage rates and programs you may or may not be approved for and where you can make improvements. You can get a free report once a year at AnnualCreditReport.com.
A credit score is a three-digit number similar to a grade. It gives lenders a sense of how likely you are to repay your debt and how risky it is to lend to you. Several different factors go into calculating your score, including your payment history, length of credit history, debts, and types of credit. There are five credit score ranges:
Very good: 740-799
Poor: Under 580
The higher your score, the better off you’ll be when applying for a mortgage. But even if you have a credit score below 600, that doesn’t mean that you can’t get a mortgage. Raising your credit score by even a few points can make a significant difference in your mortgage approval odds and may help you get better interest rates.
How To Increase Your Credit Score Quickly
There are many things you can do to boost your credit quickly.
Review your report and dispute errors.
First, review your credit report for errors. Errors are relatively common, and they can decrease your credit score. Getting them fixed by reporting them to the credit bureaus can be a quick way to bring up your score. There are three major credit bureaus: Experian, Equifax, and TransUnion. You should check your reports from all three bureaus to ensure there are no mistakes.
Make your payments on time.
The biggest factor affecting your credit score is your payment history. It makes up 35% of your FICO credit score because it tells lenders how likely you are to repay borrowed money. Paying your loans and bills on time is an important step in raising your score. Setting up auto-pay or calendar reminders is a great way to make sure you remember to make on-time payments.
Keep your credit utilization rate low.
You should also keep your credit utilization ratio below 30%. Your credit utilization rate is how much you currently owe divided by your credit limit. So, if you currently owe $1,000 on your credit card, and your total credit limit is $2000, your credit utilization rate is 50%. This is because you're using half of your total available credit. Keeping your rate below 30% is a great rule of thumb, but keeping it below 10% is even better for your credit score.
If you pay down or pay off an account close to when you go to apply for a mortgage, you can use a process known as rapid rescoring to speed up a credit update. Otherwise, it will be 30 to 45 days before this information is reflected in your credit history. A lender will need to request the rapid rescore on your behalf.
Become an authorized user or get a cosigner.
You can also improve your credit by becoming an authorized user on someone else’s credit card who has good credit. Becoming an authorized user means you're listed on another person’s credit card and you benefit from their credit history.
Additionally, you could ask a friend or family member with good credit to cosign your mortgage. Asking someone to cosign can help improve your chances of being approved for a mortgage, but it is a big request because it can negatively impact the cosigner.
Self-report payment information to the credit bureaus.
If you have a subscription to Netflix or any other recurring payment, you should take advantage of programs such as Experian Boost or UltraFICO. These programs help boost your score by adding recurring monthly payments that are traditionally not considered in your credit report. This helps strengthen your payment history.
Since your payment history is an important factor in your credit score, showing a positive history helps lenders see you’re likely to pay a loan back. These programs can be helpful for borrowers who don’t have access to traditional credit. That said, these programs will only work on the credit report pulled from the credit bureau offering the program. For instance, if you use Experian Boost it will improve your Experian credit report but not your TransUnion report.
Don’t take on new debt during the mortgage application process.
Finally, if you're already in the mortgage application process, there are a few things you should avoid doing before your loan closes:
1. Avoid taking on or applying for new debt. This can temporarily lower your score, which can negatively impact your loan terms.
2. Avoid closing any open credit accounts. This can hurt your score in two ways: First, you could shorten the average age of your credit history. Second, you may lower your total credit limit, which increases your credit utilization rate. Both of these can lower your credit score.
Lower Your DTI
Lenders will also look at your debt to income (DTI) ratio to help determine your borrowing risk. Your DTI tells your lender how much of your income is currently going toward paying off your debts. Lenders prefer a DTI of 36% or lower. This shows you have enough money coming to pay a mortgage. You can improve your DTI by paying off or paying down some of your debt.
You can calculate your DTI by dividing your monthly debt payments by your monthly gross income. That’s your income before taxes are taken out. For example, if you pay $1,000 in debt payments each month and have a gross monthly income of $2,000, your debt-to-income ratio would be 50% ($1000/$2000 = 0.50).
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Determine Your Housing Budget
Once you find your credit score and DTI, you can determine your housing budget. The lower your FICO credit score, the more likely you are to get a higher interest rate on your home loan. If the interest rate you qualify for is high, you can balance it out by purchasing a lower-priced home. This helps keep your monthly payments affordable.
A good rule of thumb is to spend 28% or less of your annual gross income on your mortgage. So, if you make $52,000 per year, you should try to find a house that will cost you no more than $14,560 per year or about $1,200 per month.
Save Up a Larger Down Payment
A larger down payment can help offset some of the risks for both you and the lender. While each situation is unique, here are a few general ways a larger down payment can help you if you have a lower credit score:
If you have poor credit when you go to buy a home, you’ll probably be approved for a lower loan amount than if you had good credit. In this situation, having a larger down payment can help you afford a higher-priced home. Saving up a sizable down payment can make it easier to qualify with some lenders, too. It shows them you have a serious interest, and you're more likely to make your payments on time since you have invested your own money.
Additionally, if your down payment is less than 20%, you'll have to pay for monthly mortgage insurance. There are two types of mortgage insurance: Conventional loans have Private Mortgage Insurance (PMI), and FHA loans have a Mortgage Insurance Premium (MIP). This insurance protects the lender, not the borrower, but the premium is added to your monthly mortgage payment. By putting down 20% or more, you avoid having to pay this insurance. According to Freddie Mac, PMI payments can add $30 to $70 per month in additional costs for every $100,000 borrowed.
If you decide to save up for a larger down payment, you can also use the time to improve your credit score. The combination of a larger down payment and a good credit score can result in a lower interest rate and lower overall monthly payments.
Shop Around for the Best Loan Options
Regardless of your credit score, you should shop around for the best mortgage lenders. Some lenders offer better financing terms than others, and you could save a lot by simply checking with various lenders.
If you're a first-time homebuyer or have a bad credit score, here are some loan programs that you should check out:
An FHA loan is a government-backed home mortgage that’s insured by the Federal Housing Administration (FHA). FHA home loans are an attractive option for first-time homeowners with low credit scores. A buyer with a credit score of 580 or higher can get a home with a down payment as low as 3.5%. If your score is between 500 and 579, you will need a 10% down payment.
Lenders set different requirements, so your specific lender might have a higher credit score requirement. If you decide to go the FHA route, you must speak with FHA-approved lenders. FHA lenders will likely look at your financial history, ability to repay, and available funds for closing the mortgage to determine your eligibility. If you recently went through a big credit hit such as a foreclosure, bankruptcy, judgment, or tax lien, an FHA loan can be a better option than a conventional mortgage because it generally has a shorter waiting period.
A VA loan is a government-backed home mortgage, insured by the Department of Veterans Affairs (VA). It is available for U.S. military servicemembers, veterans, and eligible surviving spouses. It is a great option that requires no down payment. Unlike FHA loans, VA loans don’t require you to carry PMI. VA loans are available even if you have a low credit score because these loans are less risky to lenders since they are backed by the government.
USDA home loans are backed by the U.S. Department of Agriculture (USDA) and are ideal if you're looking to purchase real estate in a rural area. This loan offers a no down payment mortgage for rural single-family residences. If your credit score is 640 or higher, you can get your loan streamlined, which expedites the loan process. If your credit score is below 640, you may need to speak directly with a USDA loan lender. If you're interested in seeing if your home is eligible, check out the USDA’s eligibility map.
Fannie Mae HomeReady Mortgages & Freddie Mac Home Possible Loans
The Fannie Mae HomeReady loan is a conventional mortgage option that allows borrowers to make down payments as low as 3%. These mortgages are financed through the Federal National Mortgage Association.
The Freddie Mac loan is a conventional mortgage option that allows borrowers to make down payments as low as 3%. These mortgages are financed through the Federal Home Loan Mortgage Corporation.
The Fannie Mae and Freddie Mac mortgages may allow you to use alternative credit to qualify. Alternative credit includes rent and utility payments. Generally, the Freddie Mac loan requires a minimum score of 660. The Fannie Mae option allows for a minimum credit score of 620. Also, both loans require you to attend a homeownership course.
Traditional banks are not the only entities that offer mortgages. You should also check out other options, such as non-bank lenders, online banks, credit unions, community banks, mortgage bankers, and mortgage brokers. They may offer lower rates and lower monthly payments.
See if You Qualify for Down Payment Assistance
There are over 2,500 down payment assistance programs across the nation that offer grants and credits to help homebuyers cover their down payment costs, often with no interest. You may be able to use the funds toward a down payment as well as other closing costs.
You can find these programs on the U.S. Department of Housing and Urban Development’s (HUD) website. For instance, if you were looking for a program in Idaho, you could use this HUD page to help you.
It is helpful to know the different terminology used for different types of assistance, including:
Grants: This is essentially free money. You’re not required to pay grant money back.
Forgivable Mortgage Loans: These loans usually come with zero interest and can be forgiven if you stay in the house for a certain time. These loans are a second mortgage on your home.
Deferred Payment Mortgage Loans: Deferred loans don’t need to be paid until you sell or refinance your home or until the mortgage period ends. These loans are a second mortgage on your home.
Low-Interest Loans: These are similar to the forgivable and deferred options and are also second mortgages on your house. But these require you to repay the loan every month, which means you will be paying two mortgages at once. You may be able to find low-interest loans with 0% interest rates depending on the lender. These are helpful because they can reduce your upfront costs and spread them over a period of years.
Matched Savings Program: This special savings account will match your contribution up to a certain limit. The match is usually dollar for dollar. The funds can be used to cover down payments and other closing costs.
Improving your credit score, even by a few points, can increase your chances of getting a mortgage and accessing lower interest rates. There are several steps you can take to improve your credit score before you buy a home. Start by taking a look at your credit report to see where you’re at right now. Check for errors and see if there are any other areas where you can improve. Making on-time payments is a great start! If you have bad credit, putting down a larger down payment can be helpful. There are also many different programs you can use to get a mortgage or get help with your down payment.