The Federal Housing Administration (FHA) loan is often referred to as a first-time homebuyers' loan,…
It’s not easy to improve your credit score after going through bankruptcy, but it is possible. However, depending on how long it has been since you had a debt turned over to collections, it can take a long while before you can see any significant rise in your credit score.
If you have a credit score of 500, chances are you have been through some rough times. And, as much as you may want to put it off, you may not have the luxury to postpone huge financial needs. One of which is buying a house.
Everyone has the right to adequate housing. With this in mind, it is good to know that there are government-insured loans that have your back when it comes to getting a mortgage despite lower credit scores.
In this article, we’re going to help you learn everything you need to know about these government-backed loans so that you can get more prepared once you apply.
Table of Contents
Subprime Mortgages vs. Government Loans
When you only have a 500 credit score, there are two main routes you can take. You can either avail of a subprime mortgage, or you can apply for a qualified mortgage.
Even now, in 2021, subprime mortgages still have a bad reputation. These days they are now more often referred to as Non-QM loans.
After the housing bubble burst in the late 2000s, it was unofficially acknowledged that subprime mortgages were the key to the economic meltdown. Subprime mortgages are basically home loans offered to borrowers with bad credit scores who do not meet traditional loans’ usual minimum credit score requirements and wouldn’t be approved for mortgages.
On the surface, it seems like a good thing. For example, suppose you can buy a house despite some very bad credit, kudos to the one who gives you this opportunity. But underneath, you have to consider what a credit score really says about your financial situation. Could you be biting more than you can chew? Because if you answer yes, you might just be digging a bigger hole for yourself.
Instead of heading down this road, it may be more beneficial to try your luck with a government loan. Remember, subprime mortgages have above-average interest rates.
So why should you choose a government loan compared to a Non-QM loan?
First of all, the QM in Non-QM stands for Qualified Mortgage. These are home loans that accept borrowers based on what’s called their ability-to-repay (ATR). If a borrower can demonstrate the necessary ATR through their credit score, debt-to-income ratio, or other factors, they can be approved for a QM loan.
A Non-QM is an opposite. If a borrower has very low ATR, they look at other items in borrowers’ financial backgrounds to approve them for loans. With Non-QM, even if you have been through a foreclosure, which can take years before being stricken off your credit report, if you can register funds in your bank account for at least a year, you can even get a mortgage in a short period of time.
Clearly, for QM loans, quality is given more importance than quantity, which is for the benefit of borrowers. But, on the other hand, for Non-QM loans, the more borrowers they can get, the better because there are higher chances of foreclosures or bankruptcies, which will work in the lenders’ favor, keeping in mind that they are already earning a lot through the more expensive interest rates.
Home Loan with 500 Credit Score
For a 500 credit score, there are two possible QMs you can apply for, and the government guarantees these. In addition, there are USDA loans and FHA loans.
Often referred to as a rural housing loan, the U.S. Department of Agriculture insures the USDA loan as a means to promote the sale of real estate in rural parts of the country. There is actually no minimum credit score required to qualify for this type of mortgage. However, with a credit score of 500, you will have to go through a lengthier application process.
In general, borrowers with credit scores over 640 might have an easier time getting a USDA mortgage because underwriting is a lot faster to do with this minimum credit score. However, if underwriting cannot be automated, an actual person will have to look over all of your financial statements to determine whether you have the necessary ATR.
Now, all of that doesn’t seem like enticing reasons to avail of this loan type. However, what most people really like about it is that there is no down payment needed to secure it. You might also be surprised by what the USDA deems as an eligible area for this kind of loan, but if you really want to be sure, you can enter your details at this website to check.
Another thing that sets USDA apart from other loan programs is you don’t exactly have to pay for mortgage insurance. Instead, you pay two types of fees that are a lot less expensive than the charges on other types of loans. There is a 1% funding fee you only have to pay one time at closing, and there is a 0.35% annual fee you have to pay over the life of the loan.
The other government loan program you will want to look into is called an FHA loan. Sometimes called a bad credit mortgage, this loan guaranteed by the Federal Housing Administration is still a very significant option in the mortgage industry because it provides opportunities for borrowers with credit scores below 670.
If you want to qualify for an FHA mortgage, you can get approved with a minimum credit score of just 500, which is already the starting credit score of 99% of American borrowers. If you get an FHA loan with this credit score, you’ll have to make a down payment of at least 10% of the home’s purchase price, but if you have a score of 580 or higher, you can pay as little as 3.5% down payment. It will really depend on how much you can afford to pay. Just remember that the lower the down payment you make, the more expensive the mortgage.
Unlike the USDA program, you can buy a house anywhere in the country using an FHA loan. And although this is aimed primarily towards first-time homebuyers with poor credit, you can still qualify even if you’ve availed of a mortgage before. However, take note that you can only have one FHA at a time because the house must become your primary residence for at least a year.
Another way that FHA loans can help low to middle-income earners is that you can seek outside help if you don’t have enough funds for a down payment. For example, friends and family can gift you with the seed money to buy your house, or you can also qualify for a mortgage grant from down payment assistance programs. You don’t have to get it all from your savings, especially if you are cash-strapped in this pandemic.
On the downside of it all, FHA loans have what you call a mortgage insurance premium (MIP). This type of insurance you have to pay for to protect the mortgage lenders if you default. That’s right, and you have to pay for it, even though it’s not for you. This is unsurprisingly not very attractive for borrowers, so most people who get FHA loans usually end up refinancing once they gain enough home equity. This is a strategy you can also employ if you have USDA since the 0.35% annual fee you pay for a rural housing mortgage is also paid over the whole life of the loan.
Subprime loans or Non-QMs have higher interest compared to government-insured mortgages. Furthermore, mortgage lenders are betting to earn bigger from their investment once you foreclose with the former. You’ll hear many different explanations for why this unconventional way of getting a mortgage will be better for you. But we’re telling you, run in the other direction!
It would be a lot safer for you to work on improving your credit instead of settling for the expensive deals lenders offer at this point.
If you have no other choice, you can still apply for FHA loans or USDA loans. But, at least with these, if an underwriter really sits down with you to tell you why you do not qualify at the moment, you’ll know that this is the truth you need to hear.
If your credit score is enough, that’s great! Maybe you have a better debt-to-income ratio, or you have very stable employment that makes up for your FICO Score. But if your bad credit bars you from getting a mortgage right now, it might be for the best! It’s actually the universe’s way of telling you that you need to be a little more patient.
Just pay your bills when you should and avoid charging everything to your credit cards, and we know that you may qualify for the mortgage loan you need in due time. Don’t stop believing!