Bad credit home loans are available
Most banks will not offer conventional loans to customers whose credit scores
fall below a certain range. Here are some examples of alternative loan programs for people with bad credit.
FHA home loans: Minimum credit score requirements
An FHA loan is a government-backed loan given to borrowers through a program supported by the Federal Housing Administration or FHA. The term "government-backed" means that the government is taking on some of the risks of the loan. This is different than a conventional loan, where the bank takes on all of the risks.
The idea behind the program is to offer lower down payments, usually 3.5%, to borrowers with lower credit scores or to those who can't save enough money for the typical 20% down payment. The program's flexible requirements allow more people to get on the path to homeownership than traditional private loans from banks.
You also won't pay any private mortgage insurance for an FHA loan, even though you are only making a 3.5% down payment, so this is one way to avoid paying PMI
However, to be eligible for an FHA loan, you must have a credit score of at least 500. This allows those who have had a little financial trouble in the past to find a mortgage option, but some will still find the credit score threshold of 500 too high. For tips on raising your credit score, check out the end of this article.
Other requirements to qualify for an FHA loan
Note that in the case of FHA loans, there are a few additional requirements in addition to a FICO score higher than 500.
For example, if you have recently filed for bankruptcy, you may be ineligible for FHA loans for a certain period of time. The period depends on the type of bankruptcy you filed.
For example, after chapter 7 bankruptcy, you must be at least two years removed from discharge to get an FHA loan. Alternatively, for chapter 13 bankruptcy, you must have made at least 12 months’ worth of on-time payments before you are eligible. Further, if you have been foreclosed on, you must wait 3 years before you can take out an FHA loan.
While these FHA loans' requirements may seem restrictive, they are designed to protect both the borrower and the lender. Since there is so much risk associated with a mortgage, the lender must ensure that the borrower will be able to pay on time, in full, on a consistent basis.
Fannie Mae Home Ready home loan: Minimum credit score requirements
Fannie Mae is one of the nation’s largest mortgage lenders. One of their top programs for those with bad credit scores is the Home Ready loan program. You’ll notice that this program has stricter requirements than the FHA loan program above.
For example, instead of the 500 minimum credit score requirement for an FHA loan, you need a FICO score of at least 620 to qualify for Fannie Mae’s program.
The requirements relating to bankruptcy, foreclosure, and tax liens are also more stringent. You must be 4 years removed from filing for Chapter 7 bankruptcy, 2 years removed from filing chapter 13 bankruptcy, and 7 years removed from foreclosure. Additionally, any tax liens or tax judgments must be paid in full.
Fannie Mae Home Possible home loan: Minimum credit score requirements
Home Possible is another program from Fannie Mae that caters to individuals or families with bad credit. It offers some slightly different loan options and interest rates than the Home Ready Program, but its requirements are mostly the same.
What is the difference between Fannie Mae's programs?
The only difference is that to qualify for a Home Possible loan, you must have a minimum credit score of 660 rather than the 620 required for the Home Ready program. All of the other requirements regarding bankruptcy and foreclosure are the same.
USDA home loan: Minimum credit score and requirements
Another way to buy a home is through the U.S. Department of Agriculture or the USDA. They offer USDA loans to customers looking to purchase a home in certain designated rural areas. USDA loans have special perks such as better interest rates or zero-down-payment loans, depending on where the property is located. In addition to the home being in a specific location, here are the requirements for a USDA mortgage.
First, you’ll need a minimum credit score of 581, which is the lowest score that is still considered “fair.” Additionally, you’ll need to be at least 3 years removed from chapter 7 bankruptcy, 1 year removed from chapter 13 bankruptcy, and 3 years removed from a previous foreclosure. A violation of any of those terms will make you ineligible for a USDA loan.
VA loans: An excellent option for veterans
If you have served in the armed forces, you may want to consider the VA to help you with your home loan. They offer many options for those with bad credit, including a low minimum credit score threshold. Check out the VA loan website for more information about their home loan options.
Other mortgage terms and situations
In addition to the total amount, interest rate, and term of your loan, there are a few other things you’ll need to be aware of to make the most of your options with bad credit.
Make a larger down payment if possible
A down payment is the lump sum you pay to the bank at the beginning of your mortgage. Typically a down payment of at least 3.5% is required, but some programs allow you to pay less depending on your credit.
As a rule of thumb, if you can save up to make a down payment, pay as much up-front as you possibly can. This could help you avoid a higher interest rate and reduce the total amount you borrow. As you'll see next, a down payment of 20% or more is preferred.
How to avoid private mortgage insurance
If you aren’t able to make a 20% down payment, you will likely have to pay private mortgage insurance
, or PMI, until you have paid off about 20% of your home’s value. To avoid it, you must own at least 20% of your home.
What is the purpose of private mortgage insurance?
Private mortgage insurance is like a safety net for the lender. Since they took an increased risk by loaning the borrower 95% of the value of their house instead of 80%, the lender needs a way to protect themselves if the borrower cannot pay.
How is private mortgage insurance paid?
Private mortgage insurance is a payment made every month in addition to your mortgage amount. Unfortunately, there is no way to avoid it in most cases other than making a 20% down payment or paying off at least 20% of your mortgage.
How to improve your credit score
Although it is possible to get a bad credit mortgage, it is obviously better to improve your credit score. Higher credit scores will increase your chances of being approved for a mortgage with lower rates.
Here are some helpful ways to raise your credit score over time. These are the things that credit agencies consider most when analyzing your credit and calculating your credit score. It won’t happen overnight, but a consistent effort in these areas over time will help your score improve.
Pay bills and taxes on time
Every month, you are likely responsible for paying things like your electric bill, cable, water, and so on. It is important to pay these on time and in full each month. These are all part of your payment history on your credit report. Otherwise, these companies will report late payments to the credit agencies, and your credit score will take a hit. Strive for zero late payments on your payment history across all of your bills by putting them on autopay each month.
Lower your debt to income ratio
When you apply to get a mortgage, banks will look at your debt to income ratio. Your debt to income ratio compares your monthly income to the amount of money that you owe to banks each month across things like student loans, car loans, and so on.
The lower your ratio, the more likely you are to get approved for a higher loan amount and a lower interest rate. The opposite is also true. A high ratio could lead to a higher interest rate or prevent you from getting approved altogether.
Stop spending on credit cards
Credit cards are one of the biggest sources of debt for people in the United States. Some people spend far beyond their means and end up owing huge amounts of money in interest. Or, they continually open new credit cards to pay off old ones. When they are unable to pay, their credit score decreases.
However, there is a better way. Follow this simple rule: if you don’t have the money for something, don’t spend it. This could mean cutting out credit card use completely if you cannot use them responsibly. Of course, you may need to spend on a credit card in the case of an emergency, but many people who struggle with credit card spending would be better off just using cash.
Check your credit report regularly
Another major step you can take to improve your credit is to check your credit report regularly. This will help you spot any errors or irregularities in your credit history, which you can then correct. It can also keep you aware of what is impacting your score so you can target major areas to change.
For example, if your high level of debt is impacting your credit score, consider trying to pay down your debt a little more quickly and cutting out non-essential monthly expenses. Or perhaps you have too many credit cards open, in which case you may consider closing a few of your accounts. In any case, staying aware and updated on your credit information will help you improve your scores quickly and target the areas that matter most.
It may be tempting to take out a big loan to buy that fancy new car, but consider the effect it could have on your credit score. You are probably better off taking out a smaller car loan and not taking on too much debt.
If you keep the amounts you borrow to a minimum, you will be more likely to stay on top of your monthly payments. This will help you avoid late payments, fees, penalties, and negative marks on your credit report that knock your score down and leave you stuck with bad credit.
Mortgage alternatives for bad credit scores
The process of trying to qualify for a mortgage when you have a bad credit score can be frustrating. In addition to the tips above, here are a couple of other options.
Consider Renting a Home
If you find yourself with a bad credit score and can't qualify to buy a home through one of the options above, consider renting a home or apartment for a few years first. Consistent payments to your landlord will raise your credit score over time, and you'll see the positive changes taking effect on your credit report.
Use a cosigner
Another option for someone with new credit or a lower credit score is to involve a cosigner
in their mortgage loan. Having a cosigner means that person is using their good credit to take on some of the responsibility of your loan and vouch for you. Not only can this help you qualify for a conventional loan, but you may be able to avoid paying higher interest rates over the life of the loan. This is another way to make buying a home more accessible, in addition to the loan programs mentioned above.
Home loans for bad credit
A low credit score can have a massive impact on your mortgage rates, or your ability to buy a home at all. It can leave borrowers with bad credit history with a high interest rate, limited loan options, and a lower total amount that they can borrow.
However, even if you have bad credit, there may still be options available for you
besides a conventional loan. It is definitely still possible to qualify for a home loan with bad credit. The first step in the process to qualify for a mortgage is to check out all of your options. VA loans, FHA loans, and the Home Ready and Home Possible loans by Fannie Mae mentioned above are all targeted to borrowers with bad credit or those who can't get approved for conventional loans. Check with your local bank or lender today to see if you qualify for one of these options.