Once you have decided that the only way forward to make that dream home purchase…
No one starts as an expert on how to handle money because we all have a learning curve. The same is true for good credit standings. Did you know that credit scores don’t actually start at zero? Just the same, you won’t have a lot of options with a lower credit rating. But just how bad for home equity loans is a bad credit score, and what steps can you take to improve your credit situation to get closer to your dream home?
The most commonly referred to credit rating in the U.S. is defined by the Fair Isaac Corporation, which is known as your FICO score. There are no lower credit scores than 300, so even if you have no information under your name, you never actually get a 0 rating. No data means no history available. But how are credit scores computed?
What’s in your rating?
Your FICO score has five components. Let’s discuss each of them below.
Payment History (35%)
It’s important to understand that your credit score only comes into existence once a financial institution starts looking into your credit background. You usually need to have availed of at least two different financial products to generate an initial score. Between your account creation and the time that your score is computed are your payment history and details. And yes, every single one of those entries will truly count! Once your initial credit score is calculated, it often gets updated every month or at least once every 45 days.
As payment history controls over a third of your score, this area will rely on your most recent loan payment submissions. Recently missed obligations can land you a poor credit score if a report is requested within a month. So if you are planning on applying for a mortgage or other types of loans, you have to know how often you pay your bills on time.
Amount Owed (30%)
Secondly, the total amount you owe across all your accounts and loans will greatly affect your credit rating. After all, credit institutions will use your score to determine just how much money you are qualified to borrow and what interest rate you can avail. A high amount of debt concerning your granted limit can put your standing in a bad light. It can give the impression that your income is spread a little too thin. It will be good to keep an average usage of 30% of your limits. Try not to go over this number as often so that even when you get an additional emergency expense, it will not have as detrimental an effect on your score.
Length of History (15)
Next, it also matters to lenders how much experience you have had as a borrower. Although your actual age may not have a bearing on your credit standing, your tenure as a borrower will. A middle-aged individual who has built a solid relationship with banking institutions might score higher on this category than someone of the same age who is just starting to add files to their credit portfolio. To compute for this, credit bureaus take a look at the age of your accounts to get their overall average.
Credit Variety (10%)
While we’re on the subject of experience, it will also slightly affect your rating if you have a more robust mix of credit accounts. There’s a whole world of loan options out there, but if you’ve only ever had student loans, you might score low on this category. It will be to your advantage if you become more exposed to different types of loans, like those on installments, credit cards, and mortgages.
New Credit (10%)
The last area of interest for lenders is your most recently opened credit accounts. Although this is only 10% of your score, it serves as a warning sign to lenders, especially if you have opened way too many over a short period. And it only makes sense. If you put yourself in the lender’s shoes, you might also feel the same way. Would you loan a colleague any money knowing that this person has made the rounds at your office, getting loans from other coworkers? Even if you know how much income this person makes, this kind of behavior can be suspicious. Lenders consider this very risky, and it can have a bearing on whether they approve your loan or not.
What exactly is a bad credit score?
Now that we know how our credit scores are computed, it’s time to find out which numbers are actually considered low credit or even bad credit. Since we’re on this topic, keep in mind that a low credit score is relative. What may not be enough for one lender may be good for other lenders. It’s important to keep your chin up and remember that scores go up and down as often as your bills arrive, and there’s always enough time to get it other control.
Strictly speaking, the worst possible score you can get is 300, and such individuals with as bad credit are very few and far between. In fact, only 1% of consumers have a FICO rating below 470. And the reasons they can have such bad credit are not too out of the box either. They may have had no payment activity at all in the last six months, or they’ve only recently been approved a loan from a lender.
Mortgage Loans for Bad Credit
If you’re planning on buying a house through a home loan, mortgage lenders will definitely be looking at your credit report and rating. When it comes to home loans, there is such a thing as bad credit. All lenders define a minimum credit score that determines whether you can get approved for a home loan. But credit history is not all that matters to qualify for a mortgage.
Every month, your income is divided into several slices. Some of your money goes into savings, some for necessities, and yet some are distributed to all of your existing loans. To measure your qualification for borrowing, lenders look at what we call your debt-to-income ratio. This term pertains to the fractional weight of your debt to your salary. When you have too many loans, leaving very little money with you every month reduces your capability to take in even more debt because that is exactly what a mortgage is.
When you still have enough money left after you’ve paid off all your loans in a given month, this gives you wiggle room for more spending which can be very attractive to lenders.
If you can satisfy mortgage lenders’ requirements regarding credit score and debt-to-income, which home loan will you be able to avail of? Let’s find out.
A mortgage from the Department of Housing and Urban Development is called a Federal Housing Administration (FHA) loan. The absolute minimum credit score you need to qualify for a loan is 500. To qualify for an FHA loan, you also need this score provided that you are also capable of making a 10% down payment on your mortgage. Since a 300 to 579 rating can be considered very poor, this is your best option if you want to buy a house with bad credit. If you rate slightly higher, at least 580, you can be allowed to get a home loan at a 3% minimum down payment. This type of loan was created with first-time homebuyers in mind since potential homeowners have a higher chance of getting a lower credit rating.
If you are a veteran or active duty member who wants to buy a house, you can also seek help from the U.S. Department of Veterans Affairs (VA) to secure a loan. As home loans go, a VA loan is one of the best mortgage types available. They call it a zero down payment mortgage, which is a truly hard-earned benefit for the military. However, aside from needing to have a service record, you’ll also have to rate at least 580 on your report. Some lenders won’t even let you get a mortgage if your score is not as good as 620.
The U.S. Department of Agriculture (USDA) also oversees applications for a zero down payment mortgage scheme. A USDA loan targets those buying a house in rural areas, regardless of industry and profession. However, as good as the deal sounds, a 640 credit score is required to avail one.
All the previously mentioned mortgage loan types (FHA loans, VA loans, and USDA loans) are government-insured mortgages. While these seem more accessible to those with low to moderate-income, they can ask for higher interest rates than other loans.
Now, if you have a better-than-average credit history, you might want to look into applying for conventional loans. These are mortgages backed by private banks and institutions that offer some of the most attractive interest rates. To qualify for a conventional loan, lenders often ask for a minimum credit score of 620, although some lenders won’t look at your application unless you score 740 or higher. However, if you satisfy the credit score requirements, you can be awarded a far better deal via this mortgage option than others. With a 740 and upwards credit score, you might only be required to make a 3% down payment.
Some people understandably tend to avoid conventional loans for fear of private mortgage insurance. This kind of insurance is paid by the borrower but is ultimately for the lender’s protection (in case of borrower bankruptcy or default). However, if you have enough liquidity to make a larger down payment (at least 20%) for your home loan, this can automatically be waived. Once you have crossed the 22% equity mark, lenders often stop charging for private mortgage insurance as well.
Your credit score can define your required down payment amount as well as the interest rate you’ll get over the life of the loan. It’s not impossible to buy a house with bad credit. But it depends on where you stand in the spectrum. The vast majority of people will have credit scores way above 500, and ultimately very few people get bad credit home loans.
Just the same, if you plan on getting a home loan with bad credit way below 500 marks, it’s never too late to improve your credit. Remember, your report is updated once a month, and you get ample opportunity every few weeks to better your situation.
Here are few tips that can help you improve your credit reports:
1 – Read your report.
Improving your credit score will entail finding out where you actually stand in the FICO range. Think of it the same way you might about losing weight. If you didn’t have one already, you might want to buy a handy weighing scale. Letting yourself become aware of how much you weigh at any given time can help you make a better action plan to get yourself closer to your goal. Read up here to find out how you can get a free credit report every week.
2 – Correct errors in your report.
It happens more often than you might expect. In fact, the Consumer Financial Protection Bureau has revealed that credit report complaints comprised 50% of all consumer complaints they received in 2020. Sometimes, one erroneous entry is the single reason barring you from getting approved for the loan program you need. Scrutinize your credit report and make sure you correct any mistakes as soon as you can. It’s your right!
3 – Watch your credit utilization.
This advice is best for those who have credit cards. One of the advantages of having a credit card is the standard limit you can borrow every month. Further, this replenishes every time that you can make a monthly payment. As previously mentioned, the amount of money you owe against your limit accounts for 30% of your credit score. Since it is easier to control credit utilization on this type of product, do your best to keep your expenses 30% or even below your credit limit.