If you are fed up with your landlord, annual rent increases and proverbially flushing money down the toilet, it’s time to get serious about homeownership. But while you like the idea of buying your own place, learning that you have a low credit score can shake your confidence.
A mortgage lender will take your credit history and credit score into consideration when reviewing your application. However, a low score doesn't automatically make you ineligible for mortgage financing. There are different mortgage products, and each loan has its own set of guidelines and rules. Once you know your options and what lenders expect, you can greatly improve your chances of qualifying for a home loan with a low score.
1. Know the Appropriate Wait Times
After a bankruptcy or foreclosure, you may feel forever banished from the lending world. But while both can tarnish your credit report for up to seven to 10 years and decrease your credit score by 200 or more points, a foreclosure or bankruptcy doesn’t permanently close the book on buying a home. Rebuilding your credit can help you realize your dream. Even if your credit score hasn’t fully recovered, you can apply for a mortgage after the required wait period.
This period varies depending on the type of loan. After a foreclosure, there’s a three-year wait period to qualify for an FHA home loan, and a seven-year wait period for a conventional loan. Some lenders will reduce the wait period if a foreclosure resulted from extenuating circumstances or events beyond your control, such as an illness, death, job loss, or divorce. A bankruptcy has a slightly shorter wait period; you have to wait at least two years to qualify for an FHA home loan and four years for a conventional loan.
2. Improve Your Payment History
You can get approved for a mortgage with a low credit score of 500 and 620 for an FHA and a conventional mortgage, respectively. But this doesn’t mean lenders approve everyone with a low score. There are limits, and banks approve applications on a case-by-case basis. It takes more than income and desire. Your recent credit habits must prove you're on the path toward better credit.
A bank will pull your credit reports and examine your payment history for the past 12 months. You don’t need perfect credit to be eligible for a mortgage, but at the same time, you can’t have more than one 30-day late payment during this 12-month period.
Of course, zero late payments are preferred. You want lenders to be confident in your ability to pay the mortgage. If you’ve been renting since the bankruptcy or foreclosure, the bank may also request information about your recent rental history from current or previous landlords to confirm you’ve made these payments on time. If you can’t pay your existing bills on time, there’s a good chance that you won’t pay your mortgage on time.
3. Give the Bank a Bigger Down Payment
Although you can qualify for a mortgage with a low credit score, you’re not likely to qualify for the lowest mortgage rate. Some borrowers underestimate the financial importance of getting a low rate. Interest ultimately determines how much you pay for your house. That said, someone with a low credit score could end up paying considerably more than someone with a high credit score.
For example, a borrower with good credit may purchase a $200,000 home and qualify for a low 3.25% fixed-rate for 30 years. This person would pay about $870 a month (excluding taxes and insurance). A borrower with bad credit may apply for the same mortgage, but pay one percentage point higher because of a lower credit score. This one-percent difference increases the monthly payment to $983.
Even if you’re approved for a mortgage with a low score, you might be uncomfortable with a higher monthly payment. Mortgage loans typically require a minimum down payment between 3.5% and 5%. To compensate for a low score and higher mortgage rate, consider purchasing with a larger down payment. The good news is that a 20% down payment means you won’t have to pay private mortgage insurance, and it might help you get a slightly better rate. But you don’t have to increase your down payment this much, a 10% or 15% down payment can make a big difference.
A larger down payment reduces the amount you need to finance. So although you might get stuck with a higher rate, you can keep the monthly payment within a comfortable range.