You don’t need to have an exceptional FICO Score or a credit score in the 800s to qualify for a mortgage. While still challenging, it is possible to buy a house even with credit scores as low as 500 due to government-insured loan programs.
You need to know if you pass the other qualifications and have enough money to make a down payment.
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Check Your Credit
So you have a 580 credit score. Before we talk about home loans, let’s make sure you look at the correct FICO Score that will matter in a mortgage application.
Note that if you purchase a home with a partner, your partner’s credit score can also affect your application. This is because the final credit score that the mortgage lender will consider will be the lower credit score between you and your partner’s scores.
To determine your rating, you have to look at your credit reports from all three major credit bureaus: Experian, Equifax, and TransUnion. If you get three different FICO Scores from them, your middle score will be your official FICO Score. If your median score is lower than your partner’s middle FICO, this will be the one used by mortgage lenders and vice versa.
580 Credit Score Home Loans
When you have a 580 credit score, you’ll have a difficult time applying for conventional loans.
These are your traditional Fannie Mae and Freddie Mac mortgages that ask for credit scores of at least 620. They make it harder to get these loans because if you can put down 20% out of pocket, they won’t have to charge you for private mortgage insurance (PMI). This kind of insurance protects the lender in case you stop paying your mortgage.
The lower your credit score, the higher the risk that you will default.
Since you have 580, your best chance of buying a house through a home loan can be found through a government-backed mortgage. Home loans used to be a privilege only of those with good to exceptional credit scores. Different government agencies have set up their loan types to make mortgages more attainable for poor credit.
To find out which one will be the right choice for you, you have to ask yourself, how much money do I have in reserve for a down payment?
If you don’t have enough savings
One of the great things about government loans is they have options for if you’re just down on your luck, as long as you’re willing to compromise.
If you buy a house in an area that the U.S. Department of Agriculture defines as rural, you can get ahold of a USDA loan. Regardless of your credit score.
When we say rural here, the USDA considers population, so it doesn’t have to be a ranch or in the middle of nowhere if you imagine a farm. You can’t use the house for commercial purposes, and you’ll have to live in it for at least one year. Surprisingly, some urban areas still count as rural for the USDA because they have a very sparse population.
Aside from not asking for a down payment or a particular minimum credit score, another thing going for the USDA loan is the low funding fee and insurance you have to pay. Compared to the FHA loan, which we’ll talk about later, you only need to pay a 1% funding fee included in the mortgage and annual mortgage insurance of 0.35 percent, which you have to pay for the life of the loan.
You can also qualify for another type of mortgage insured by the government if you are a veteran.
The Department of Veterans Affairs guarantees 25% of a mortgage if you are or have been a service member, as long as you were honorably discharged. Since they already back a considerable part of the loan amount, you don’t have to make a down payment anymore, and at the same time, the lender has less risk, so there is no mortgage insurance. But to use this benefit from the VA, you have to pay a very minimal funding fee which will depend on your loan amount, down payment amount and entitlement. Remember, you are not obligated to put any money down, but you can still choose to do so. Even putting 1% down will decrease your total mortgage expense.
The VA does not prescribe credit requirements for this loan. Although mortgage lenders generally have their overlays, it is still easier to qualify on a lower credit score due to the significant guarantee.
If you are an eligible veteran spouse, you can also apply for a VA loan as long as you have not remarried.
If you can put money down
Not needing to make a down payment sounds excellent, especially if you want to use your money for something else. But what if you aren’t buying rural or you are not qualified for VA? You either have no choice but to pay, or you choose to do it off your own accord. After all, the more money you put in, the more equity you gain sooner.
Another government option that you can get is an FHA loan.
The Federal Housing Administration was established under the Department of Housing and Urban Development to, first and foremost, promote growth in the housing industry. As long as the market is solid and other industries follow, enabling more people to get closer to the American Dream.
To make this possible, there is a low minimum credit score requirement. For example, to qualify for an FHA loan, you only need a credit score of 500.
Since you have a 580 credit score, you have two options as far as down payment is concerned. You can either pay as low as 3.5% down, or you can choose to make at least a 10% down payment. This is in consideration of mortgage insurance.
FHA loans mostly accommodate borrowers with lower credit scores, so the lender has a much higher risk. In addition to this, they also have the option to put very little money down. To make lenders feel more comfortable doing this, the borrower has to pay for two types of mortgage insurance. There is an upfront one and a monthly premium.
This is 1.75% of your total loan amount for the upfront fee, and you pay this at closing. For the mortgage insurance premium (MIP), it is 0.85 percent. The down payment matters because if you can pay at least 10 percent, the MIP stops after 11 years. If you pay below 10 percent, since you have the option to pay only 3.5 percent, the MIP stays for as long as you are repaying the loan. So it’s a serious decision you have to think about when you choose how much you will pay at closing.
To guide you in this, it’s good to plan and research if you can do a refinance down the road. Unfortunately, it is often the case that borrowers find it very difficult to refinance an FHA loan. Most lenders will tell you that you can do this eventually, but if you choose FHA, you have to be open to the possibility that you will retain it for the complete loan term.
Our advice? It’s better to make a 10% down payment.
If you can’t do either
Still, you might find yourself in a situation wherein you can only qualify for an FHA loan because you’re not eligible for a USDA or a VA loan. But, at the same time, you don’t have the liquidity to deposit a down payment even if you are obliged to forward just 3.5 percent.
A great feature of the FHA loan program is you don’t need to get all of your down payment funds from your savings.
Here are some other possibilities you can look into.
Family and Friends
If you are lucky enough to have family members willing to help you secure this loan, they can do this in two ways. If they are financially capable, they might be able to gift you the cash needed, but they’ll have to sign a document to put in writing that they are giving this money to you. Since it’s a gift, there can be no strings attached, so they can’t ask you for payment at any time in the future.
Now, you cannot get your down payment money from your credit cards as in a cash advance, and this is also true for the relatives who will help you out. They are, however, allowed to borrow money on your behalf through a collateralized loan. It will be by your arrangement with your relative how you will repay the loan.
If you have a friend who has a specific interest in getting you approved for this FHA loan, they can also gift you funds. Note that the FHA will ask for documentation to illustrate this friend’s interest.
Down Payment Assistance Programs
There can also be local down payment assistance programs partnered with the FHA to assist you in this area. However, these may not be found in all states, and the chances are, it will be harder to qualify for this other loan. And yes, it will be another kind of loan you’ll be taking in, so be mindful that you do this only as a last resort.
What should my debt-to-income ratio be?
Due to all the focus on credit scores, it can be easy to forget that there are other factors you need to focus on to make sure that you qualify for a loan.
Another critical requirement you have to prepare for is your debt-to-income ratio (DTI). This percentage represents how much of your income goes to your combined monthly debt. If you want to qualify for a mortgage, the ideal number is below 40% after your potential home loan amortization has been included.
There can be cases when you have a much higher DTI that the lender does not prefer, but if you have a higher credit score or make a higher down payment amount, you can still get yourself approved.
How can I improve my debt-to-income ratio?
Two things affect your DTI. First, there are your existing debts, and of course, your salary.
You want to lower your DTI in the months leading to your mortgage application, and you can do this by paying down your debts, increasing your income, or doing both.
Why did the mortgage lender reject my application?
As we’ve mentioned, whether it is the FHA, the VA, or the USDA, the minimum credit score requirements are generally mere advisories of these government agencies. They do not pressure nor oblige lenders to enforce these credit score requirements. The agencies also do not give out these loans; the money will still come from private lenders.
This being the case, lenders still have the right to set their overlays, whether this is their minimum credit score or preferred DTI.
Can I rent out my house if I have a mortgage?
For all of these government loans, you are required to use the house as your primary residence for one full year. After that, you can’t use the mortgage for an investment or vacation home. Once your mortgage is approved, you must be able to move into your new home within sixty days.
However, if more than one unit in the house, you can rent out this unit. Maybe you’re getting a duplex or even a quadruplex. What is essential is you will also be one of the occupants. Under the FHA, you can get up to 4 units and rent up to 3 of these units.
This strategy is often called house hacking, and you may want to discuss this with your lender to ensure you do not overlook any of the rules for the mortgage you’ll be getting. Once you complete your year of residency in the home, you can now open to renting out the whole house.
Is the FHA loan my best option?
The FHA loan program is the most basic type of mortgage that most American consumers will qualify for. Since it only asks for a minimum of 500 for your FICO, and you can buy a house anywhere in the country, nearly everyone should be eligible.
Still, you have to look at your circumstances to arrive at this judgment. The FHA loan will be the best choice for you if there is no other loan you can qualify for. That said, if you do get an FHA loan, we advise that you keep on the lookout for an opportunity to refinance in the future, significantly if you can improve your credit score.
Note that refinancing involves getting another mortgage entirely, which will come with its own set of expenses. Weigh if the costs will be worth it in your scenario.
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