The process of buying a home can be daunting and overwhelming, even at the best of times. If you happen to have a poor credit score, then getting approved for a mortgage loan might seem almost impossible.
However, your credit score may not be as much of an obstacle in your homebuying journey as you anticipate. Some lenders specialize in working with borrowers with bad credit, and various government agencies also offer home loans for bad credit in order to encourage homeownership within different sections of society.
So, let’s jump straight in and learn a bit more about the most widely available home loans for bad credit and what you’ll have to do to qualify for one.
Getting Approved for a Home Loan with Bad Credit
As mentioned above, certain public agencies offer government-insured loans to borrowers with bad credit in order to promote homeownership among people who might not otherwise have had the financial means to buy a home. These agencies include:
- The Federal Housing Administration (FHA)
- The United States Department of Veterans Affairs (VA)
- The United States Department of Agriculture (USDA)
We’ll learn more about these agencies and the types of mortgage loans they offer further down the article.
Getting approved for such a government-backed loan might be your best bet if you’re trying to secure a mortgage with a bad credit score. This is because most conventional lenders are wary of lending to borrowers with a FICO score lower than 620 since they represent a substantial credit risk.
However, you could get approved for a home loan even with a bad credit score if you demonstrate a steady employment history, high income, substantial cash reserves, a low debt-to-income ratio, and a higher-than-average downpayment on the property you’re planning to purchase.
Understanding Bad Credit
Before you can effectively apply for and utilize home loans for bad credit, you first need to understand what bad credit is, what causes it, and how it can be improved.
When it comes to your credit score, the first thing you need to know are the five factors that help determine your score and their relative importance. These are as follows:
- Payment History (35%): This is the record of your on-time or delinquent payments on each of the accounts on your credit report, including credit cards, installment loans, lines of credit, etc. Too many late or delinquent payments in the recent past will significantly lower your credit score.
- Amounts Owed (30%): Also known as the credit utilization ratio, this is a track record of how much debt you’ve taken on compared to your available credit limits. If the credit utilization ratio on one or more credit cards is too high, it could negatively impact your credit score.
- Length of Credit History (15%): This helps potential lenders figure out how long you’ve been managing debt and making timely repayments. If your credit history is too short, you’ll be seen as a credit risk by lenders since you don’t have a track record of making timely payments on your loans.
- New Credit (10%): If you’ve recently applied for many new credit accounts, this could negatively impact your credit score since it would indicate to lenders that you’re planning to take on lots of new debt or experiencing cash flow problems.
- Credit Mix (10%): Lastly, the types or variety of your credit accounts will also have a small impact on your credit score. Having a good mix of different types of credit, such as credit cards, installment loans, and store accounts, will help improve your credit score.
The Fair Isaac Corporation (FICO) ranks individuals by their creditworthiness on a scale of 300 to 850. Generally, if you have a score below 580, you’d be considered a ‘credit risk’ by most conventional lenders, making it hard for you to qualify for a home loan.
How Bad Credit Affects Home Loan Eligibility
Most mortgage lenders see a low credit score as a red flag, indicating that you may have a history of late payments, debt delinquency or defaults. Hence, lenders would see you as a ‘high-risk’ borrower who might default on the loan or have trouble paying it back on time.
As a result, a low credit score might make it harder for you to qualify for a loan with a traditional mortgage lender. Even if your loan application is approved, you may have to deal with a higher interest rate or less-than-favorable repayment terms because of your low credit score. You may also be required to make a higher downpayment in order to qualify for the mortgage.
A low credit score could also limit the amount of money you can borrow for your home loan, as lenders may be reluctant to approve a higher loan amount due to fears of a default. In addition, you’d have to pay a higher interest rate than a borrower with good credit, which could potentially lead to higher monthly payments or a longer repayment term, despite having made a bigger downpayment.
Is It Still Possible to Get Home Loans with Bad Credit?
Yes, it is possible to get a home loan even if you have a poor or bad credit score. Of course, bad credit might limit your options when it comes to choosing a lender and your loan options, and it may require you to pay a higher-than-average interest rate on the mortgage. However, you can certainly still qualify for the home loan if you meet certain other conditions.
- Choose the Right Lender: Work with lenders who specialize in offering home loans to borrowers with bad credit. These lenders might require a higher downpayment, lower debt-to-income ratio, stable employment history, and also charge a higher interest rate.
- Work with a Credit Counselor: If you can afford it, hire the services of an experienced credit counselor to help you manage your finances, quickly pay down your debts, and improve your credit score.
- Apply for Government Programs: Various government agencies offer government-insured mortgage loans to help borrowers with bad credit become homeowners. Look into the programs that you might be eligible for and start applying for a mortgage loan through them.
Lastly, whether or not you can qualify for a home loan with bad credit will also depend on the cause of your bad credit score. If the poor FICO score is the result of a few late payments or a limited credit history, then many lenders would be willing to approve your loan application. However, if your credit is bad due to a recent foreclosure or bankruptcy, you might find it much harder to get a home loan.
What Types of Home Loans are Available for Bad Credit?
If you have a poor credit score, here are a few bad credit home loans that you can choose from, depending on your situation.
These loans are offered by the Federal Housing Administration (FHA) to make homeownership more accessible to people with lower credit scores and imperfect credit histories.
The FHA provides government-backed mortgage insurance to lenders, ensuring that they will be protected against losses in case the borrower defaults. This allows mortgage lenders to offer loans to people who have relatively poor credit scores.
To qualify for an FHA loan, you need to have a minimum credit score of 580 and a down payment of no less than 3.5% of the total purchase price of the home you’re planning to buy.
You can also get an FHA loan with a credit score as low as 500 if you can make a down payment of at least 10% of the purchase price of the property. You’ll also need to pay a slightly higher interest rate if your credit score is around 500.
Having a low debt-to-income ratio and a steady income and employment history will also increase your chances of qualifying for an FHA loan.
Guaranteed by the U.S. Department of Veterans Affairs, these mortgage loans are available only to active-duty service members, veterans, or the surviving spouses of deceased military personnel who meet all the eligibility criteria of a VA loan.
While the VA does not specify a minimum credit score, most lenders require a minimum score of 580 to approve an application for a VA-backed mortgage loan.
If approved for a VA loan, you can get a mortgage with no down payment, a competitive interest rate, and no private mortgage insurance. The Department of Veterans Affairs also offers various types of assistance to borrowers in order to help them avoid default or foreclosure in the event of any financial hardship.
To help rural borrowers with low-to-moderate incomes and below-average credit scores become homeowners, the U.S. Department of Agriculture offers USDA loans with flexible credit requirements and low-interest rates. If you qualify for a USDA loan, you could potentially buy a home with no down payment.
To be eligible for this type of bad credit home loan, the property you’re buying must be your primary residence and located in a USDA-designated rural area. Furthermore, your total household income should not exceed the local USDA income limits.
Some private lenders specialize in providing mortgage loans to borrowers with poor credit scores. Some examples of such lenders include:
- Subprime mortgage lenders, who exclusively provide loans to borrowers with lower credit scores.
- Online lenders typically have more flexible requirements and faster loan application and approval processes.
- Credit unions often have more lenient credit score requirements for mortgage loans than traditional banks.
The tradeoff is that these lenders will usually charge a higher interest rate than conventional mortgage lenders to offset the additional risk they’re taking on. Therefore, you should shop around and compare the offers from multiple lenders before choosing the home loan that best suits your needs.
Home Loans for Bad Credit: How to Get Approved
Now that you know what types of home loans are available for borrowers with a bad credit score, it’s time to discuss the steps you need to take in order to actually get approved for these loans. Here are a few of the things you should try to improve your chances of qualifying for a mortgage loan:
Review Your Credit Reports
You can request a free copy of your credit reports annually from the three major credit reporting agencies (Experian, Equifax, and TransUnion). So, before applying for a home loan, get all three credit reports and review them thoroughly, looking for any errors or inaccuracies that might be negatively affecting your credit score.
If you identify any such inaccuracy, dispute it immediately with the concerned agency. This might help raise your credit score, making it easier to qualify for a home loan with reasonable interest rates.
Pay Down High-Interest Debts
Take the necessary steps to reduce your debt-to-income ratio by paying down some of your current debts (particularly those with the highest interest rates) before you apply for a home loan.
Most lenders (especially those backed by government agencies like the FHA and the USDA) prefer to work with borrowers with a debt-to-income ratio of 40% or less. A low debt-to-income ratio is even more essential for borrowers who have a bad credit score.
Make All Payments On-Time
Be sure to pay all your bills on time in the months (or years) leading up to your application for a home loan. A history of on-time bill payments will prove to a potential lender that you’re financially responsible and have enough cash flow to easily manage your current obligations.
One easy way to do this is to sign up for auto-pay so that you never fall behind on your recurring bills (such as car loans or utilities) by mistake. Always paying your bills on time will also help you avoid late fees and unnecessary dents on your credit score while simultaneously improving your payment history.
Know How Much You Can Afford
The most important thing to remember when trying to get a mortgage with bad credit is – you mustn’t buy more houses than you need or can afford. In the U.S., there’s a belief that the bigger your home is, the better must be your lifestyle.
The average size of a newly-built U.S. home has increased from around 910 square feet in the 1950s to 2,480 square feet in 2021, even though the average number of people living in those homes has declined significantly over the same period.
However, the problem with buying more homes than you need is that it’s both environmentally and financially unsustainable. Not only will you be taking on a bigger mortgage (and higher monthly payments) to buy an unnecessarily large house, but you’ll also need to buy more furniture, carpeting, and appliances to fill up the larger space, all of which will put a further strain on your budget and drive you deeper into debt.
Hence, carefully consider your options and be sure to buy a house that can comfortably accommodate your family without overstraining your finances.
Save for a Larger Down Payment
No matter what your credit score is, you’ll usually need to save for a down payment when planning to buy a home. This is, however, doubly important if you have a FICO score between 500 and 580. In that range, you may have to make a higher-than-average downpayment (up to 10%) in order to qualify for a mortgage.
So, start by making a budget and setting aside a small sum of money every time you get a paycheck. A substantial amount of savings will be needed to cover your closing costs and other fees associated with buying a home. It will also demonstrate to the lender that you’re not overstretching yourself financially to buy a house.
Get a Co-Signer
To improve your chances of qualifying for a home loan with a bad credit score, you can ask a family member or a friend to co-sign your mortgage. As long as your co-signer has a better credit score, this will make your loan application more attractive to lenders.
This is because, at least on paper, the co-signer will be just as responsible for paying back the loan as you are, and any late payments will negatively affect their credit score as well as yours. Therefore, the co-signer will have a huge incentive to hold you accountable and ensure that all the mortgage payments are made on time.
Essentially, there are two main things you need to do in order to qualify for a mortgage loan with poor credit. First, you need to explore different types of mortgage lenders – including those offering government-backed home loans – to find the one that best suits your needs.
Secondly, you need to make a budget, start saving for a downpayment, pay your bills on time, and get your finances in order before applying for the loan, as much as you can. These steps will help you get the best possible loan terms despite your low credit score.
How to Get a Home Loan with Bad Credit
Are you looking for a home loan approval but have bad credit? Mortgage lender Top Flite Financial works with people like you that have less-than-perfect credit to secure a mortgage loan, as they only require a 500 minimum credit score to consider you for a loan. Offering both purchase mortgage loan options and refinancing, you only need to answer a few questions to get in touch with a mortgage expert from their team and see if you qualify.