Can I buy a home with bad credit?
This is a common question, and many potential home buyers assume the worst if they have a troubled credit history. Yes, you can buy a home with bad credit. But the home loan options are likely different or limited compared to those buyers with higher credit scores.
You’ll find that government backed loans, such as the VA loan, FHA loan, and USDA loan, have relaxed requirements compared to conventional loans. Each has their own specific guidelines, but borrowers do not need a perfect credit history to become qualified.
Before diving into the home loan alternatives suited for those with questionable credit, here’s a refresher on some of the acronyms and definitions associated with the home loan applications. You’ll find them throughout the loan qualification descriptions.
Terms to Know for Home Loan Applications
FICO Score
This is the personal credit score calculated by the company FICO, formerly named Fair Isaac Co. FICO gathers personal financial information to determine an individual’s risk for taking on more debt and assesses their ability to pay bills on time. FICO uses credit reports from Equifax, Experian, and TransUnion to determine an applicant’s credit score.
Experian breaks down their credit ratings as such:
- Exceptional: 800-850
- Very Good: 740-799
- Good: 670-739
- Fair: 580-669
- Very Poor: 300-579
Experian also reports that 67% of Americans have a Good or better FICO score.
Debt to Income Ratio (DTI)
Lenders use a DTI formula to determine the risk involved with offering you a loan. DTI divides total monthly debt payments by gross monthly income; 20% is the standard for what is considered a low DTI.
Private Mortgage Insurance (PMI)
Conventional mortgage lenders usually require home buyers to purchase this insurance if they offer less than 20% down payment. The insurance protects the lender from loss if a foreclosure occurs.
Mortgage Insurance Premium (MIP)
The FHA loan calls for homebuyers to purchase an insurance policy if the down payment is less than 20%. It is either paid at closing or paid in 12 installments.
Loans Available for Those with Bad Credit
The following loans are backed by the federal government and prove easier to obtain for those with low credit scores. The overall goal of the VA, FHA, and USDA loans is to provide as many eligible Americans with the opportunity to become homeowners. The details vary, but overall, the qualifications are less strenuous than traditional home loans.
The VA Loan
By far, one of the easiest ways for a military member to work around a low credit score is to take advantage of their VA loan benefit. Mortgage lenders are much more willing to offer VA loans with competitive interest rates to applicants because of the U.S. Department of Veterans Affairs’ guarantee.
Learn more:
Although there is no set credit score requirement, 620-640 is the typical range lenders use to qualify a servicemember for a VA loan. The VA loan is also more accessible for servicemembers to secure because a down payment is not required, nor is PMI. And, for those with troubled financial histories such as a bankruptcy, the VA Loan is a forgiving option. Uncle Sam also tolerates a higher DTI ratio.
For all the benefits a VA loan provides a servicemember with bad credit, it does have a drawback with the funding fee assessed. Borrowers can pay the funding fee separately or within the home loan. In some situations, military members with disabilities can apply to have the funding fee waived. Click here to view the VA's Funding Fee Tables.
FHA Loan
FHA loans are known for leniency on qualifications. The Federal Housing Administration initially created this loan program to help those earning low to moderate incomes become homeowners. Here are the details:
- Minimum credit score: 580.
- Down payment as low as 3.5%.
- Higher DTI is acceptable if the credit score starts in the mid-600s.
- Some FHA lenders will accept proof of fewer than two years of employment.
It is possible to qualify for an FHA loan if you’ve experienced bankruptcy or foreclosure, but the mortgage lender requires proof to see if good credit has been maintained after the debts were settled. FHA applications may be submitted between one and two years past bankruptcy and three years beyond foreclosure.
There is a misconception that the government only offers FHA loans to first-time buyers. This is not the case—any buyer may apply. However, those who put less than 20% down will have to pay MIP for the entire length of the loan.
USDA Loan
These loans have similar qualifications to the FHA and VA loan programs, but are offered through the U.S. Department of Agriculture. The intent is to provide mortgages to low to average income earners in rural areas.
- No set credit score standard, but a score of 620 is typical.
- Zero down payment is required.
- DTI percentage of 50 or lower is needed.
- PMI is not required.
The loans are processed through the USDA Rural Development Guaranteed Housing Loan Program. The majority of loans are designated for rural settings, but it's a good idea to check with a USDA-approved lender because there are surprising nooks and crannies of suburban locations that are eligible.
4 More Options to Find a Loan if You Have Bad Credit
If you’re unhappy with the terms provided by the FHA, VA, and USDA loans, there are other options but are likely challenging.
1) A substantial down payment can offset bad credit.
A hefty sum assures the lender you can pay the monthly payment. Lenders recognize your seriousness as a homebuyer by investing in the property with a substantial amount of money. With cash in hand, more loan products are available.
2) It's a contentious suggestion, but for some, asking a family member with good credit to cosign a home loan is plausible.
A co-signer is on the hook for the mortgage each month if you are unable to make payments.
Should you be unable to pay, the burden that falls on your co-signer could wreak havoc on their financial stability. A co-signing deal should not be entered into unless each signer acknowledges the details and responsibilities.
3) Federal agency Fannie Mae provides first-time homebuyers who might not have a substantial credit history the opportunity to purchase foreclosed homes with as little as 3% down.
The program also offers up to 3% of the purchase price back in closing cost assistance.
With their partner HomePath Ready Buyer, Fannie Mae requires applicants to become educated on the home buying process through coursework on their app.
4) The Department of Housing and Urban Development (HUD) has a state-by-state directory that leads homebuyers to state and local government-assisted home buying programs.
How Can I Improve My Credit Score?
Credit scores are not permanent. There are many options to repair credit problems and increase your credit score, which will allow lower interest rates on loans and open more possibilities from lenders. Give yourself plenty of time before applying for a home loan to correct botched credit.
Begin by examining each of your credit reports.
Errors vary from incorrect addresses to evidence of identity theft. The credit bureaus offer online assistance for filing disputes and corrections. Any corrections made, especially regarding late fees or outstanding balances, help to increase your credit score.
Continue to pay all of your bills on time and in full.
Do not let any unpaid accounts move into collection. If you find a collection account on your credit report, work diligently to remove it by communicating with the creditor to figure out a manageable payment schedule.
Reduce your overall DTI.
Paying off remaining balances on car payments, credit card bills, or other debts helps free up more money to pay for a mortgage. Lenders like to see a DTI that sits under 43%. This is the percentage reached after factoring in the mortgage payment each month.
Possessing a large amount of unsecured debt, such as credit cards, medical bills, or student loans, is a red flag for home loan lenders and credit bureaus. Look at your credit utilization ratio for credit cards, lenders, and credit bureaus to see if you are “maxing out” available credit. For example, a $1,000 limit credit card with an $800 balance is unfavorable, given your credit utilization ratio is 80%. Work to pay off the balances, and your credit score will improve.
You should feel relief knowing bad credit doesn’t automatically negate the chance to own a home.
There are several viable options, but expect some financial sacrifices, whether it's a higher interest rate, larger down payment, or the need for PMI.
Reevaluating how much of your income you can reasonably put toward a mortgage is a simple way to start considering which home loan choice may be right for you. After that, use referrals to find a mortgage lender who has experience working with those who have less than perfect credit. Their expertise will help avoid unnecessary mistakes and wasted time.
Financing is a large part of what homeownership is all about. For more information, head over to MilitaryByOwner’s home financing resource articles to begin researching everything you need to know, and download our free ebook below!
