How to Buy a House With Bad Credit
The downsides of renting a home or apartment can make the goal of buying a house feel urgent, but if your credit isn’t where it needs to be, you may want to slow down and think it through.
The good news is that you might be able to buy a house with bad credit. (Depending on just how bad it is.)
The bad news is that it will cost you!
VA, FHA, or USDA loans might approve you with a lower credit score than what’s conventionally accepted, but you may have to make some compromises to make up for your bad credit score.
What is Considered a Bad Credit Score?
A bad credit score is more than just a number.
Mortgage lenders consider your entire credit and financial profile when reviewing your loan application.
Even if you’ve brought your score up to a decent range, you could still get held up by your debt to income (DTI) ratio or your Loan to Value (LTV) percentage. Those two are a little more complex, so we’ll revisit them later.
Let’s talk about what makes a credit score bad.
If you’ve done the work of pulling your credit report, your score will fall under one of the ranges below with a rating from Poor to Exceptional. A bad score would be in the Poor to the low Fair range.
- Under 580: Poor
- 580-669: Fair
- 670-739: Good
- 740-799: Very Good
- 800+: Exceptional
Bad credit scores tell lenders that your history of repaying your debts and maintaining your accounts isn’t favorable. They see it as potentially putting them at risk of losing money if they approve your loan.
This can look like too many late payments, accounts in collections, high revolving debt balances, and bankruptcies.
To balance the risk of taking on a loan with a bad score, your mortgage lender could include requirements for your home loan that borrowers with good scores wouldn’t have to meet.
These extra requirements can take away some of the cost-saving benefits of homeownership.
So before you apply for a mortgage with bad credit, it’s best to determine what your goals are for becoming a homeowner. Then decide whether the compromises are worth it.
Can You Buy a House if You Have Bad Credit?
But it’s much more expensive.
In many cases, even when your lender can qualify you with a low credit score, they’ll likely need a large down payment of anywhere from 10%-20% depending on the type of loan.
They could also apply a higher interest rate which means tens of thousands of dollars more in interest over the life of your loan.
A better option is to work on raising your score first and then apply. It’s a long-term strategy, but you can learn how to raise your score 200 points and gain the benefits that come with it:
- You may get to choose the loan option you want, not just the one you qualify for
- Save thousands of dollars in interest
- Lower monthly payment
- Lower down payment
- The loan approval process can sometimes be easier and faster.
How Does Bad Credit Affect a Home Loan Application?
When you’re working with a credit score of 500-579, it can put a big damper on your home loan application. It’s likely your only option will be to get a federally backed FHA loan.
Once the lender reviews your application, they can make additional requests to qualify you for the loan. This can be a huge hold-up to the home buying process, especially if you didn’t get pre-qualified.
- The lender can ask for a 10% minimum down payment if your score is below 580
- They can require all outstanding debts to be paid in full before granting the loan
- They could require additional documentation regarding your financial history
All of these extra steps and documentation can add valuable time to how long your loan takes to process.
In a hot housing market, every minute counts.
Having bad credit can make the application process slow down and take much longer, which may cause you to miss out on houses you’ve had your eye on.
Home Loan Options
Each type of home loan has different requirements and features that you can compare to choose the best option for you.
Some of these options aren’t just dependent on your credit score alone.
Factors like Debt-to-Income (DTI) and Loan-to-Value (LTV) can be instrumental to meet if the credit requirement isn’t in your strengths column.
A Debt to Income Ratio is a simple formula that adds together all your monthly debt payments (rent, revolving credit lines, loans) and divides the total by your monthly income.
Total monthly Debt Payments: $2,000
Total monthly Income: $5,000
$2,000 / $5,000 = 40%
Mortgage lenders will want to see your DTI under 36%.
The Loan-to-Value compares the home’s value to the value of the loan.
If your house is worth $200,000 and you make a 20% downpayment of $40,000, your loan amount is $160,000.
You then divide the loan amount by the home’s value.
$160,000 / $200,000 = 80% LTV
If you have an LTV of over 80%, you might get some pushback from your loan officer since it’s considered a riskier loan.
These loans are common and most major financial institutions use them.
They can have rigid requirements in comparison with other loans. Most mortgage lenders will accept a minimum credit score of 620 for a conventional loan.
It always helps to bring your score up as much as you can to get the best rate. It’s recommended that you have a credit score of at least 680 to apply for a home loan. For comparison, keep in mind that the average credit score in 2020 in America was 711.
Conventional loans typically boast competitive interest rates and can have a varying down payment from 5%-25% depending on your credit report.
If you’re looking to go for this type of loan with a low credit score, you’ll need to make sure your DTI is below 36% to give yourself the best shot at approval. It’s smart to have a healthy down payment as well.
Federal Housing Administration loans have one of the lowest credit requirements. The minimum score they’ll accept is a 500, but not without plenty to make up for it on the back end.
While FHA loans are ideal for first-time homebuyers, they’re restrictive when it comes to borrowers with lower credit.
With an FHA loan, you should prepare to:
- Put at least 10% down with a score below 580
- Demonstrate consistent employment history for at least two years
- Pay for Private Mortgage Insurance or PMI in your monthly payments
- Only work with an FHA approved lender
The upside is they only require 3.5% down payments for borrowers who have reached at least a 580.
Active service members, veterans, and their spouses are the only ones who can qualify for VA loans. It’s because these loans are almost too good to be true.
- No minimum credit score
- Backed by federal funds
- Little to no down payment is required
- Minimal interest rate
- And they allow mortgage lenders to use other aspects of your financial history to prove creditworthiness
There’s not much of a downside here.
The US Department of Agriculture offers loans to people with low-to-moderate income who are buying a home within an eligible rural area.
While many lenders look for a 640 when deciding on a USDA loan, there’s no minimum credit score and no down payment requirement. There’s also no mortgage insurance.
Instead, the mortgage lender can consider other parts of your financial history to qualify you.
How Much Extra Will A Low Credit Score Cost Me?
Having a low credit score is expensive.
According to myFICO.com, a $200,000 home with a 30 year fixed mortgage would cost a borrower with exceptional credit (760-850) a monthly payment of $792.
Over 30 years, they would pay $85,274 in interest.
Not bad, right?
A borrower with a 620 credit score would pay $176 more each month for the same house. They would also be paying an extra $63,047 in interest for their loan.
House Payments by Credit Score
|FICO Score||APR||Monthly Payment||Total Interest Paid|
What would you do with an extra $63,000?
Buy a bigger house? Pay for your child’s college? Pay down your debts and be debt free faster? Travel the world when you retire?
So yes, you can buy a house with bad credit, but that doesn’t mean you should.
And it certainly doesn’t mean you have to.
How To Improve Your Credit Score:
There are several solid ways to improve your credit score before you start the home buying process. You’ll have to be patient. Improvements to your score can take months to show, but it’s worth it.
- Dispute any errors on your report
- Open a credit builder account
- Pay down your revolving debt—raise your credit score by improving your credit utilization rate
- Make all of your payments on time, every time
- If you’re not applying for the mortgage loan within the next few months, look into opening new accounts
Having a “thin” credit profile can be detrimental when improving your credit score. A “thin” credit file means that you don’t have many credit accounts or a good credit mix in your credit profile. Opening accounts that build credit can boost your score and decrease your credit utilization in some cases.
No matter what your goals are, there’s an account that can fit your needs and help build a healthy credit profile.
Pro Tip: If you’re only a few months from applying for a mortgage, you’ll want to put a pause on new credit applications. Even if your score has shot into a better range, some lenders may frown upon a credit profile with multiple new credit accounts or hard inquiries.
Get a Credit Builder Loan
If buying a house is a goal you want to reach in 6 months to a year from now, a great solution to increasing your credit score would be to get a credit builder loan.
Consistently making on-time payments with your credit builder loan shows potential lenders that you can meet long-term payment obligations.
If you have a thin credit profile, it also works by increasing your length of credit history which can determine 15% of your overall credit score. New borrowers who are starting to build their credit history find this very helpful in improving their scores.
Check Your Credit Report For Any Discrepancies
Credit bureaus and creditors can make mistakes sometimes.
When you look at your credit report, do you see…
- The same account reported multiple times?
- A collections account that hasn’t fallen off after seven years?
- An account that was paid on time and was still reported?
These situations can be disputed to have the errors removed. Once they’re gone, you could see a healthy jump in your credit score.
Make On-Time Payments
Your payment history is the key to improving your credit score. It also prepares you for the responsibilities of homeownership. According to FICO, your payment history determines 35% of the impact on your credit score.
When you have consistently made your payments on time for a year or more, it can work wonders for your credit. But just one late payment can cause a drop of up to 180 points.
The amount of the drop can be affected by factors such as how late the payment was, your current score, and how recent the late payment was in your history.
Avoid Too Many Hard Inquiries
Hard inquiries are anything that requires you to pull your credit score to be approved for an account. It can come from:
- Credit card applications (yes, even store cards)
- Applying for a loan
- Starting a new cell phone plan
Just to name a few.
You want to avoid getting a ton of hard inquiries because each one stays on your report for two years.
Multiple recent hard inquiries can also be a sign of financial troubles to a lender. Not something they want to see when deciding to approve a home loan.
To avoid hard inquiries, always ask if this is going to be a “hard pull” on your credit before applying.
Overall, buying a home with bad credit is not the easiest thing to do. You’ll need plenty of planning, patience, and savings to make it work.
You may encounter some obstacles along the way. When you go in with a clear strategy and discipline, you can turn your goal of owning a home into a reality.
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