Technically, whatever your credit score, you can always find a way to buy a house.
Many people may not be aware of this, but if you know someone who is already having trouble paying their home loan, you can ask them to pass the mortgage on to you so you can take ownership of the house without having to change the name in the loan or get a mortgage yourself. It’s a win-win because you get to have a mortgage, and your friend doesn’t end up with a foreclosure on their credit report.
If you don’t have a credit score, there will be lenders out there who can do manual underwriting so that they can still assist you. During manual underwriting, you have to form a picture of your credit score in a more unorthodox way. For example, the underwriter might need all the receipts on your bills within the last couple of years. However, this route can often be the longest one to take.
It is still preferable to have and maintain a credit score to get a loan faster should you need it.
But what if you have a 500 credit score? What can this get you as far as mortgages are concerned? Should you go ahead and try your luck at applying for a home loan, or should you wait a little longer and see if you can improve your credit score?
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How bad is a 500 credit score home loan?
There is such a thing as bad credit, and it’s not just to make you feel dejected when your credit score is not high enough. Instead, it refers to a particular range.
Indeed, the way the credit scoring system is set up, consumers are encouraged to get on their best behavior. You always want to pay your bills on time and not leave any balances in your debts. Therefore, the sooner you can pay off your loans, the better.
How Bad is Bad Credit
Bad credit, as it is so-called, is any credit score that falls below 670. After that, we refer to the FICO Score, which starts at 300 to 850 points, where 850 is the highest. Whether you’re getting your credit report from Experian, Equifax, or TransUnion, this will most likely be the score you will see and will be used by lenders when you apply.
There are other types of credit scores, and these also define a particular bad range of credit. However, what remains the same is a specific credit score you should reach if you want to have one that they say is in the excellent range.
As regrettable as it may sound, however, the credit scoring system functions as a way of protecting the economy. That is, as long as rules are being followed and the system is respected.
The lower your FICO Score, the fewer options you can have as a consumer. You might not be able to get a phone plan, a credit card, or a personal loan. This may not be good for you as an individual but imagine for a second that they just kept lending borrowers any amount of money, regardless if they were flight risks or already had foreclosures in the past. Yikes!
Unfortunately, you don’t have to imagine because this did happen during the late 2000s, in the years that led to the Financial Crisis. Today, lenders are supposed to be a lot stricter when approving and rejecting loans so that a similar disaster does not occur in the future.
If we’re sincere, as long as you maintain a 500 credit score, it won’t be easy to find mortgage lenders who will let you borrow money. It might be a long shot, but you may have to make up for it through a much better debt-to-income ratio or a larger down payment.
Regardless of advisories, lenders often set their requirements. Aside from credit scores, there are debt-to-income ratios, assets, and a history of employment you’ll have to prepare when you apply for a home loan.
Your best bet with this kind of credit score is an FHA loan.
FHA loans are government-backed mortgages under the Department of Housing and Urban Development. If all mortgage lenders follow what the Federal Housing Administration prescribes, you’re only supposed to have a minimum credit score of 500 to qualify for an FHA loan. And then you’ll only have to worry about the other prerequisites.
One of these other demands is making a 10% down payment based on your home’s purchase price. It is different for borrowers who have a 580 credit score or higher. They will only need to put forward a 3.5% down payment.
Downside of FHA
Since FHA loans can approve you at such a low credit score, you must be wondering, what’s the catch since I only have a 500 credit score?
There is, indeed, a downside, although it may not be as terrible as you might expect.
When you get an FHA loan, you sign a promissory note. A mortgage is a collateralized loan wherein your house serves as the security in case you default. Aside from this guarantee, however, mortgage lenders need another way of minimizing their risk. After all, the amount of money borrowed for a home loan is usually in the hundreds of thousands of dollars.
For FHA loans, this guarantee comes in the form of mortgage insurance, for which there are two separate ones you have to note. The first is the up-front mortgage insurance (UFMI), which is 1.75% of your loan amount. This can either be charged to you at closing or rolled into your monthly mortgage. The former is preferable because it will earn its interest if you include the UFMI in your actual mortgage.
After the UFMI, you also have a monthly insurance premium (MIP) that starts at 0.45% (in some cases, it can be as much as 1.05%).
Unfortunately together, these insurance charges already put the borrower at an inconvenience. But ultimately, it just makes sense because the poorer credit a borrower has, the likelier the scenario that they might walk away from this responsibility.
Other government-backed loans technically don’t have this feature. But for the VA loan, here is what you call a funding fee, and there is a guarantee fee for the USDA loan. So these essentially take the place of insurance and function in the same way as the FHA’s MIP.
Although the insurance fees may not seem like much, they can still amount to a few thousand dollars. And when you factor in the years in the life of the loan, it becomes no joke when you realize that you have to pay for these charges for a minimum of 11 years. If you spend at least a 10% down payment for FHA, the insurance needs to be paid for at least 11 years. If you can only pay less than 10 percent, they stay on for the life of the loan.
What is the worst-case scenario?
By now, we hope we’ve made a case for why the credit scoring system must gatekeep mortgages. Aside from protecting the economy, however, there are also government measures to shield borrowers from predatory lending practices.
From Subprime to Non-QM
Let’s go back again to the 2007-2008 Financial Crisis. At the time, the protections in place that were supposed to hinder risky borrowers from obtaining large loan amounts were widely disregarded. This was the issue with subprime mortgages.
It’s the basic definition of a bad credit mortgage. So if you can’t qualify for a mortgage the traditional way, say, if you don’t have employment documentation but have enough savings or don’t have a credit score because you have no other debts, subprime is how you can get a mortgage.
Of course, there are many reasons why a person may get a low credit score or none at all. And there are also positive things to note about subprime mortgages. These are additional opportunities Americans can grab in pursuit of the American Dream. However, on the macro-level, the effects can be catastrophic. And we already saw the consequences of it years ago.
Today, sadly, we are starting to see subprime mortgages make a comeback in the guise of what they call Non-QM loans.
When we say qualified loans, these are your traditional mortgages, so there are conventional loans from private lenders and government-insured loans. Non-Qualified Mortgages or Non-QM are everything that is outside these standard definitions.
Even if you have a 500 credit score and the FHA says this is okay, the reality is you might be waiting a long time before you can buy a house. You might eventually then be attracted to Non-QM loans since these are the most straightforward alternative.
The reason it would be better still to wait until you qualify for an FHA loan is first because of the much higher interest rates that Non-QM loans tend to have. Even when you factor in the mortgage insurance and the built-in interest for FHA loans, the government-backed mortgage will be the cheaper choice. Secondly, we encourage you to do your best to research all you can on your Non-QM lender. Talk to their previous clients, who are already paying their mortgages monthly, so that you can get a better picture of their lending practices. It is still a road you can take if you can no longer delay a home purchase.
Credit scores may take the form of a number, but they hold more value than a mere figure. You can also think of them as the title of your financial story. When you apply for a mortgage, this story is what mortgages lenders will care about so that they can decide whether or not to grant you a loan. This is the story of what opportunities you were given and what tragedies may have befallen you to have gotten poor credit.
The critical thing to remember is your credit score can also tell you whether you are financially ready to take on a mortgage. It can be very tempting to buy a house, especially when you hear that mortgage rates are at an all-time low and when you get tired of spending quarantine in your old home. Since your credit score is based on your more recent behavior, it can be a wake-up call, especially if you find yourself in the lower credit spectrum. Keep your chin up, though, because credit scores can take a turn in as fast as a few weeks.
The decision is up to you whether you will choose to get an FHA loan later or if you will go for a Non-QM loan now. You can ask yourself the following questions to help you make your choice:
- How soon do I need to buy a house?
- How much money do I have in reserve for a down payment?
- How much steady income do I expect to receive in the next few years?
- Will I be able to refinance my loan in the future?
- Am I willing to work on improving my credit?
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