Homeownership has long been viewed as a key ingredient in the American dream, but for the approximately 1 in 6 Americans (16%) with bad credit, getting a mortgage can seem out of reach. However, while bad credit may make it more challenging to purchase a house, it is by no means impossible. Read this guide to learn how to buy a house with bad credit.
Can You Buy a Home With Bad Credit?
Yes, you can purchase a home with bad credit, there will likely be more challenges than there would be otherwise. Mortgage lenders heavily weigh would-be borrowers’ credit scores and credit histories when making lending decisions. Often, people with bad credit are ineligible for some types of home loans.
Banks and other private lenders require borrowers to have fair or average credit scores for conventional mortgage loans. The minimum credit score requirement for a fixed-rate conventional loan is 620, and for an adjustable-rate loan, it’s 640. Lenders may approve borrowers with lower scores in limited circumstances, but in general, conventional loans aren’t available to people with bad credit.
The good news is that conventional loans aren’t the only option. There are a variety of lenders and programs that offer the opportunity for those in this situation to enjoy homeownership.
Keep reading to learn the best methods for purchasing a house with bad credit.
What Is Considered Bad Credit?
A consumer is considered to have bad credit if they have a low credit score due to past credit difficulties.
Credit scores are measured on a scale of 300 to 850, with scores ranging from 300 to 669 considered “poor” or “fair, and those with scores between 670 and 850 considered “good,” “very good,” and “exceptional.”
A person with bad credit possesses derogatory marks on their credit history. These are negative items considered red flags to lenders, such as late payments, collection notices, repossessions, past foreclosures, and bankruptcy filings. Lenders see people with bad credit as higher-risk borrowers because, as the saying goes, “the best predictor of future behavior is past behavior.”
Consumers with lower scores may have difficulty getting approved for loans and may be considered “subprime” by potential lenders. Being designated as a subprime borrower creates specific issues for those shopping for a mortgage, such as higher interest rates or the necessity of a larger down payment.
How Bankruptcy Affects Home Buying
Having a bankruptcy on your credit history isn’t uncommon. In the five years prior to Sept. 30, 2022, there were more than 2.8 million personal bankruptcy filings nationwide. Bankruptcy offers people with unmanageable debt a fresh start, but this process makes it harder to qualify for loans, including mortgages.
Bankruptcy remains on a person’s credit history for up to 10 years; however, it’s possible to buy a home much sooner. People filing for Chapter 7 bankruptcy may be eligible for a conventional home loan at least four years after their bankruptcy was discharged. For Chapter 13 bankruptcies, the waiting period is two years after discharge.
The waiting periods are shorter for some non-conventional loans, such as Federal Housing Administration or Veterans Affairs loans. Using those options, borrowers could be approved for a home loan with bad credit two years after their bankruptcy was discharged.
Steps for Buying a House With Bad Credit
Having bad credit can make it harder to get loans, but that doesn’t necessarily mean it’s impossible to buy a home. There are many strategies would-be borrowers can use to improve their chances of obtaining an affordable mortgage for a house they love. Here are some of the best strategies for doing just that.
1. Make Yourself “Less Risky” to Mortgage Lenders
As with all loans, mortgage rates and approval are determined by the level of “risk” they present to a lender. In this case, “risk” is determined by specific financial benchmarks, such as credit scores.
The process of evaluating the risk level of a borrower begins with a credit analysis. This involves reviewing the would-be individuals’ finances and estimating their ability to repay the loan. Borrowers deemed more likely to miss payments are classified as high-risk and may not be approved for credit.
Consumers with lower credit scores are generally considered riskier to lenders, while those with higher scores are less risky. However, people with bad credit can take several steps to become lower-risk borrowers: Lowering their debt-to-income ratio, making a larger downpayment, working on their credit, or getting a cosigner.
Lower Your Debt-to-Income Ratio
A debt-to-income ratio is a way to measure how much of a person’s income goes toward paying their debts. It’s calculated by dividing a person’s total monthly debt payments by their gross monthly income and is expressed as a percentage. For example, someone who spends $2,500 on debt repayments and earns $5,000 monthly has a DTI ratio of 50%.
Requirements vary from lender to lender, but the standard maximum DTI ratio for conventional mortgage loans is 45%. However, lenders generally prefer DTIs of 36% or less. To lower your DTI, pay down existing debts or look for ways to increase your income.
Make a Bigger Downpayment to Improve the Loan-to-Value (LTV) Ratio
A loan-to-value ratio measures the size of a home loan compared to the home’s value. It’s calculated by dividing the mortgage amount by the property value. For example, if a person puts down $20,000 on a $400,000 home, they’ll borrow $380,000, resulting in an LTV ratio of 95%.
Lenders use LTV ratios to calculate the risk of loaning money. Higher LTV ratios translate to higher risk. For this reason, lenders may require LTV ratios of 90% or lower for borrowers who want to buy a home with bad credit. Borrowers can lower their LTV ratio by providing a larger downpayment or, if that’s not possible, shopping for a lower-priced home.
Take Steps to Improve Your Credit Score
Aspiring homeowners with bad credit can become more appealing to mortgage lenders by taking steps to rebuild their credit history.
One of the primary actions consumers can take to improve their credit is paying their bills on time. If you tend to be forgetful, try setting up payment reminders or automated payments. Other helpful steps include paying down debt and getting in the habit of paying off credit card balances each month. Be patient: Turning bad credit into fair credit can take 12 to 18 months.
Secure a Cosigner
A cosigner is a person who agrees to serve as a backup borrower for someone else’s home loan. If the primary borrower fails to make mortgage payments, the cosigner becomes responsible for the home loan. This helps with mortgage approval because the lender transfers some of their risk to the cosigner, typically a person with higher better financial indicators.
Lenders typically expect cosigners to have high credit scores and long credit histories. Some mortgage lenders also require cosigners to be related to the primary borrower. Consider asking a parent, grandparent, or sibling with good credit to cosign, but only if you are confident you can make the payments.
2. Consider a Non-conventional Loan
Conventional loans, those that a government agency does not insure, may not be available to people with bad credit, but fortunately, they’re not the only mortgage option. There are also non-conventional loans that offer more flexible mortgage requirements and qualifications.
There are three government agencies that insure mortgages:
- The Department of Veterans Affairs
- The U.S. Department of Agriculture
- The Federal Housing Administration
By agreeing to insure mortgages, these agencies make it possible for lenders to issue loans to borrowers who don’t meet traditional lending standards.
Veterans Affairs (VA) Loans
The VA Home Loan benefit helps eligible military veterans, service members, National Guard/Reserve members, and surviving spouses purchase homes, often without a downpayment.
These mortgages are issued by participating private lenders and backed by the VA. The loans appeal to military personnel with bad credit because the VA doesn’t have a minimum credit score requirement.
VA lending guidelines permit past credit mistakes so long as borrowers have made efforts to establish their credit. Generally, this means making payments on time for at least 12 months. The waiting period after bankruptcy is two years unless extenuating circumstances exist.
United States Department of Agriculture (USDA) Loans
The USDA issues or backs home loans to encourage homeownership in rural communities. These loans are available to low to moderate-income households who live in eligible rural areas, as determined by the USDA.
The USDA doesn’t set a minimum credit score requirement, but some lenders that offer USDA-guaranteed mortgages look for scores of 620 or higher. Lenders that don’t require a specific score still check an applicant’s credit report to ensure they’re able and willing to repay the loan.
Generally, consumers who had a bankruptcy or foreclosure must wait 36 months to qualify for a USDA loan. However, lenders may waive this requirement in certain circumstances.
Federal Housing Administration (FHA) Loans
FHA loans are government-backed loans that help low to moderate-income families become homeowners, and they’re available to a broader range of consumers than VA or USDA loans.
FHA loans are a popular mortgage for bad credit because the minimum credit score is 500. However, borrowers with scores between 500 and 579 are required to provide a 10% downpayment. People with scores of 580 or higher can put 3.5% down.
Like other government-backed mortgages, FHA lending guidelines forgive past credit mistakes. Borrowers may qualify for an FHA loan two years after a discharge of bankruptcy or three years after a foreclosure.
What is Downpayment Assistance?
Downpayment assistance programs provide eligible homebuyers with some or all of the funds they need for a downpayment. They’re offered by state Housing Finance Agencies (HFAs). Some states offer this assistance through forgivable grants, while others provide loans that must be repaid.
These programs are designed to reduce barriers to homeownership for low and moderate-income people. Downpayment assistance allows people with limited savings, including those with bad credit, to qualify for a home loan. Contact your HFA for program details.
3. Shop Around for Conventional Loans
Conventional home loans are mortgages the government does not back, instead offered by banks, credit unions, and other financial institutions. Eligibility criteria and loan features may vary from one lender to another, so consider shopping around to find the right home loan with bad credit.
Shopping around involves comparing mortgage loan options from different lenders before applying. Minimum credit scores, minimum downpayment requirements, and mortgage interest rates may vary depending on the lender. Work with a mortgage broker to help evaluate and compare home loans for bad credit.
What Are Zero-Down Mortgages?
Zero-down mortgages, also known as 100% home financing loans, don’t require a downpayment and are offered by credit unions and some major banks. Zero-down loans appeal to borrowers with limited savings, but they may not be an ideal mortgage for bad credit.
Waiving the downpayment requirement is riskier for lenders, so they typically limit these loans to borrowers with good credit. Minimum credit score requirements vary but are generally 700 or higher. Those that do not have this level of credit may be required to have private mortgage insurance.
Mortgage insurance is an insurance policy purchased from a private vendor that provides payment to the lender if you default on your loan. Unfortunately, the additional cost could make the monthly payments out of reach for those already struggling to produce a substantial down payment. Keep in mind that those applying for government-backed loans may also have to purchase mortgage insurance.
4. Get Pre-approval For Your Mortgage
A mortgage pre-approval is a tentative offer from a lender and is an estimate of how much a consumer may be able to borrow if they formally apply for a mortgage loan. For people with bad credit, it’s also confirmation that getting a conventional mortgage is possible.
During the pre-approval process, lenders review borrowers’ finances, including employment, income, and debt levels. They check credit reports for potential red flags, such as late payments. If you’re declined, ask the lender what you could do to get approved in the future.
You Do Not Necessarily Need to Wait to Buy a Home
Since some mortgage lenders offer home loans for people with bad credit, borrowers do not necessarily need to work on rebuilding their credit before looking for a home. Some potential advantages of going ahead and buying a home with bad credit include:
- Building home equity: Making mortgage payments helps build home equity, which is the difference between the amount owed on the mortgage and the home’s market value. Home equity can be borrowed against to make large purchases such as renovations or college tuition.
- Improving your credit history: Making consistent, on-time mortgage payments shows financial responsibility and can help improve a borrower’s credit score.
- Deducting homeownership expenses: Homeowners who itemize their taxes can deduct mortgage interest, insurance premiums, and state and local real estate taxes to reduce their taxable income.
However, buying a house with bad credit isn’t the right choice for everyone. Some potential downsides to consider include:
- Limited mortgage options: While there are various methods of getting a mortgage with bad credit, a wider range of options are available to borrowers that do not.
- Higher interest rates: Borrowers with low credit scores typically receive higher interest rates than borrowers with higher scores. Having a higher mortgage interest rate increases the cost of the loan.
- Added financial strain: People with financial issues, such as high credit card balances, may feel financially stretched if they can get a home loan with bad credit.