Can I buy a home with bad credit?
This is a common question, and many potential homebuyers assume the worst if they have a troubled credit history.
The answer is yes, buying a home with bad credit is possible. However, 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 specific guidelines, but borrowers do not need a perfect credit history to qualify.
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Terms to Know for Home Loan Applications
Before diving into the home loan alternatives suited for those with questionable credit, here’s a refresher on a few acronyms and definitions associated with home loan applications. You’ll find them throughout the loan qualification descriptions.
FICO Score
Your FICO score 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. Using credit reports from Equifax, Experian, and TransUnion, FICO determines 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
71% of Americans have a Good or better FICO score.
Debt to Income Ratio (DTI)
Lenders use a DTI formula to determine the risk of offering you a loan. DTI divides total monthly debt payments by gross monthly income. 35% or below is considered a standard low DTI.
Private Mortgage Insurance (PMI)
Conventional mortgage lenders usually require home buyers to purchase this insurance if they offer less than a 20% down payment. The insurance protects the lender from loss if a foreclosure occurs.
Mortgage Insurance Premium (MIP)
The FHA loan requires homebuyers to purchase an insurance policy if the down payment is less than 20%. It is either paid at closing or paid in twelve installments.
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Loans Available for Those with Bad Credit
Federal government-backed loans could be more attainable for people with low credit scores. The overall goal of the VA, FHA, and USDA loans is to provide as many eligible Americans the opportunity to become homeowners. The details vary, but generally, the requirements 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 since they're backed by the U.S. Department of Veterans Affairs guarantee.
Although there is no set credit score requirement, 620-640 is the typical range lenders use to qualify a service member for a VA loan.
Service members find the VA loan easier to obtain since it does not require a down payment or PMI. And, for those with troubled financial histories such as 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 service member with bad credit, its only real drawback is the funding fee. Borrowers can pay the funding fee separately or within the home loan. In some situations, military members with disabilities can apply to waive the funding fee.
FHA Loan
FHA loans are known for leniency on qualifications. The Federal Housing Administration initially created this loan program to help those with low to moderate incomes in achieving homeownership.
Here are the details:
- Minimum credit score: 580.
- Down payment as low as 3.5%.
- A higher DTI is acceptable if the credit score starts in the mid-600s.
- Some FHA lenders will accept proof of less than two years of employment.
It's possible to qualify for an FHA loan if you’ve experienced bankruptcy or foreclosure. However, the mortgage lender requires proof that the applicant has maintained good credit since settling debts. Buyers may submit FHA applications 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 homebuyers. However, any buyer may apply. That said, you will have to pay the onetime UpFront Mortgage Insurance Premium (UFMIP) and Mortgage Insurance Premiums (MIP) for 11 years or the entire length of the loan.
USDA Loan
USDA 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 or average income earners in rural areas.
- There is no set credit score standard, but a score of 620 is typical.
- A zero down payment is required.
- A DTI percentage of 50 or lower is needed.
- PMI is not required.
The USDA Rural Development Guaranteed Housing Loan Program processes the loans. Most of the loans are given to those in 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.
Options to Find a Loan if You Have Bad Credit
There are other options if you’re ineligible or prefer to move forward without an FHA, VA, or USDA loan. However, they will likely be challenging.
1. A larger down payment.
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 when you invest substantial money in the property. With cash in hand, more loan products are available.
2. Cosign the loan with someone you trust.
It can be a controversial suggestion, but 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 should you fail to make payments.
While it can be helpful, the burden on your co-signer could wreak havoc on their financial stability. You should not enter a co-signing deal unless each signer acknowledges the details and responsibilities.
3. Buy a foreclosed home.
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 complete coursework on their app to learn about the home buying process.
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.
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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 opens the door to lower interest rates on loans and more options from lenders. Allow yourself the time to make adjustments before applying for a home loan.
Begin by examining each of your credit reports.
Errors vary from incorrect addresses to evidence of identity theft. 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.
Don't 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 under 43%, after factoring in the monthly mortgage payment.
Possessing a large amount of unsecured debt, such as credit cards 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.
Bottom line: 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 consider 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 buying a home. For more information, head over to MilitaryByOwner’s home financing resource articles to research everything you need to know, and don't miss our free homebuying guide below.
