The Federal Housing Administration (FHA) loan is often referred to as a first-time homebuyers' loan,…
Many people tend to get antsy when it comes to knowing their credit scores, that they might probably do whatever they can to avoid getting any loan. However, the reality remains that sooner or later, you will need to borrow money for something you really need.
This is true for home purchases.
The good news is, the greater majority of people will most likely qualify for mortgages. If this is news to you, don’t worry because we’ll explain later. Still, it will be to your advantage if you did your best to avoid buying a house with bad credit. Not only will a low credit score give you limited loan options, but it can also make you pay so much more in the long run due to the interest that you will accrue.
Today, let’s talk about what it means to get a loan with bad credit and what you can do so you can improve your score and get access to better financing for your dream home. No matter how tough it seems, this is definitely doable, and you’ve come to the best place to get the advice you need!
Table of Contents
Credit Scores: How bad is a bad score?
Did you know that your credit score is not only significant for qualifying for a mortgage or getting a credit card? It can also drastically affect where you are allowed to rent or even where you get to work.
Sometimes, landlords and employers conduct credit checks to see if you can be depended upon, whether it is paying your rent or doing the tasks that your job will require. For this reason, you must be well aware of where you stand in the credit score range.
In this section, you will find out how you weigh on this financial scale.
There are different types of credit scores, but for this article, let’s refer to the FICO scoring model, which is the most common credit score referred to by the biggest credit reporting bureaus.
The Fair Isaac Corporation categorizes credit scores into 5 ranges:
- 300 to 579 is considered Poor;
- 580 to 669 is considered Fair;
- 670 to 739 is considered Good;
- 740 to 799 is considered Very Good;
- and 800 to 850 is considered Exceptional.
Basically, any credit score below 670 is already considered a bad credit score. However, you might be surprised at the number of opportunities you can still avail of even without a high rating.
Since FICO Scores start with a minimum of 300, it is actually impossible to get a zero credit score. This number is calculated based on your recent credit history, so if you just haven’t built any history yet, it is more likely you don’t have a credit score at all.
The following are the criteria that add up to your FICO Score:
- Payment history: 35%
- Total amounts owed: 30%
- Length of credit history: 15%
- Mix of credit: 10%
- New accounts: 10%
As you can see, payment history is the most significant factor that makes up our credit scores. This is why missing just one payment can already shave a lot of points off your rating. Creditors also want to take note of just how much money you owe from everybody else because this affects your debt-to-income ratio, which determines just how much more debt you can afford to acquire. How much history you have with financial institutions also weighs on your credit score; that’s why it’s good to retain a lot of your old accounts. Your experience with different financial instruments can also put a good word in for you because this is considered a sign of how reliable you are as a borrower.
Finally, banks also want to know how many accounts you’ve recently opened, or even just had applied for to gauge whether they will be taking on risk. It’s never a good sign when a borrower decides that several credit lines are no longer enough.
Several factors affect mortgage rates.
Undoubtedly, interest rates are determined by the market. A lot of mortgage companies tend not to advertise their rates because the interest changes all the time. However, regardless of the direction the economy is going, the one thing you have control over that will definitely affect your mortgage costs is your credit score.
Aside from being a qualifying factor for certain loan types, your credit score is also used to determine just how much you can be allowed to borrow and how much interest you should be asked to pay for over the life of your loan. Remember, even the tiniest decimal percentage in interest can mean hundreds or thousands of dollars over the course of twenty years or more. But there is a lot to unpack about credit scores and how these affect your mortgage options.
Let’s begin with the types of mortgages and their minimum credit score requirements.
Types of Mortgages
If you have a poor FICO Score, a Federal Housing Administration Loan may be the best option for you.
According to Experian, nearly everyone has a FICO Score over 500, which means that 99% of borrowers can actually get a home loan to get one step closer to their American Dream.
To qualify for an FHA loan, you need a minimum credit score of 500, which will allow you to make a down payment of 10 percent. If you can get your score just a bit higher at 580, this will allow you to borrow up to 96.5% of your home’s purchase price. However, keep in mind that making a lower down payment, regardless of the interest rate, will mean that you will pay more dollars in the long run.
While an FHA loan is a government-insured mortgage meant to provide opportunities for first-time homebuyers, a conventional loan is a complete opposite.
Conventional loans are privately-backed mortgages for those who might have a little bit more experience borrowing money. Just like FHA loans, you can also make as little as a 3% down payment on a conventional loan. However, most people prefer to make a larger down payment of at least 20% to avoid private mortgage insurance, which protects the banks, not the borrowers.
The minimum credit score needed to qualify for a conventional mortgage is 620. However, the closer you get to this number, the higher your interest can become.
Next, we have another government-backed mortgage but this time insured by the Department of Veterans Affairs.
VA loans are prevalent and in demand because of the highly competitive interest rates and the zero down payment required to secure a loan. However, you can only be approved for one if you have had experience as a service member, and you will need to have a credit score of at least 640.
Finally, if you still think that you are out of any loan options due to bad credit, you can always go for a USDA loan.
The U.S. Department of Agriculture insures these mortgages, and like VA loans, they do not require a down payment, with the caveat that you will need to buy a house in a rural area as defined by the USDA. But what’s really great about USDA loans is they don’t actually ask for a minimum credit score.
If your credit score is 640 or higher, that’s really great! But you can still be eligible for a USDA loan even if your score falls below this number. Take note, though, that a credit score less than 640 will require manual underwriting, and they might really ask a lot of whys to understand the reason for your bad credit.
Credit Scores and Mortgage Rates
Now that you have read about some of the loan options you can choose from out there, you probably now have a pretty good idea of what kind of mortgage you can already apply for. And if you haven’t realized it by now, the minimum credit scores set by these loan types are actually those that fall under bad credit!
That’s right. Even conventional loans can require no better than a fair credit score. However, you need to realize that mortgage lenders will always have the final say on whether you qualify. Remember, your credit score will only be one of the factors to be considered in your application.
Often, borrowers with bad credit might need to convince mortgage lenders further by putting forward a much larger down payment. However, that might sound a little bit confusing. After all, why would someone with a lot of liquid cash have poor credit? Well, keep in mind that many people with bad credit might actually be short in their borrowing history. This can be because some people can get by without credit cards or without leaving a financial trail. Sometimes, these potential borrowers are simply fresh out of college and, therefore, just newly embarking on their financial journeys.
To summarize, there are several cons to contemplate if you plan to get a mortgage with bad credit.
- The poorer your credit, the fewer your options are, and the fewer the lenders who might be willing to negotiate.
- Lower credit scores also mean that you will need to make a bigger down payment to secure the loan.
- And the higher your interest rate, the more expensive each monthly payment will be later on.
How to Improve Your Credit Score
It only makes sense to want to work on your credit before you shop around for a home loan, especially if you would like a particular type of loan. By improving your credit, you can avoid buying a house with bad credit and save yourself hundreds to thousands of dollars in the process.
Here are a few steps you can take to improve your credit:
- Check your credit report. To start, you need to have a baseline to know much you need to work on or if you need any help at all. Since you are planning to get a mortgage, you will need to get all your credit reports from the three biggest bureaus: Equifax, Experian, and TransUnion. Don’t be surprised if you actually get different scores from each of these companies. But take note that the score lenders consider is the middle score among these three—not the average.
- Dispute any errors in your report. Chances are, your credit report will be fair and accurate. But, there have definitely been instances wherein people have reported inconsistencies in their credit reports and even ended up suing companies. You will do well to make sure that these mistakes are not what’s giving your name bad credit so you can get it to the level you need much faster.
- Pay attention to your credit utilization ratio. Now, this might take some computation on your part, but there is a magic number that you can remember – This magic number is 30. So, to put it simply, make sure that you never go over 30% of your credit limits. This will show lenders that you still have enough money left every month even after you’ve paid your bills and that you’re a responsible borrower.
So, there you have it. It may be tough going once you decide to go down the mortgage route, but with a little determination and a ton of discipline, raising your credit can be something you can accomplish in a few months. Instead of thinking about how much you want to avoid bad credit home loans, remember that what you really want to avoid are the excessive fees you might get with a lower credit score.
Are you ready?