Purchasing a Home with Bad Credit Is Possible: Here's How

Bad credit, which generally is reflected by a credit score of 600 or lower, can make getting credit cards and loans more expensive and difficult, but it doesn't have to be a deal-breaker when applying for a mortgage. The following are three steps borrowers can use to purchase a home with bad credit.

Get an FHA Loan

The Federal Housing Administration (FHA) insures home loans with premiums paid by borrowers, which protects lenders should a borrower default on a mortgage. As a result of the protections provided by FHA insurance, lenders can offer mortgages to borrowers with less stringent qualification standards than those placed on conventional loans. For example, borrowers with credit scores of 580 or higher can be approved for an FHA mortgage with a down payment of 3.5%. Borrowers with credit scores between 500 and 579 can get approved with a down payment of 10%.

FHA loans have an upper limit of $625,000 or 115% of the median value of homes, whichever is lower, depending on the region. For example, in San Francisco, where the median home price was $1.1 million in 2016, the FHA lending limit is $625,000. In St. Louis, the upper limit on FHA loans is $278,000, due to a relatively lower median home value in that area. Because the FHA is an insurer, not a lender, borrowers should shop around for mortgages, as interest rates and fees can vary widely among FHA-approved financial institutions.

Offer a Larger Down Payment

While credit score is one of the major considerations for conventional lenders, borrowers may be able to make up for a low score by saving a down payment of at least 20%. Coming in with a larger down payment delivers three results that may persuade a lender to approve a mortgage. First, a large down payment provides evidence that the borrower has the ability to save money. Second, a large down payment reduces the loan-to-value ratio, as additional equity in the home generally reduces the chances of a default on a mortgage and mitigates risk for the lender if a default on the loan occurs. Lastly, this strategy reduces the debt-to-income ratio, which can increase affordability for the borrower by reducing monthly mortgage payments.

Reduce Lender Perceptions of Risk

A low credit score signals higher risks for lenders, but credit reports are composed of numerous factors that may either confirm or reduce the perception of risk. For example, a history that includes a high charge-off rate on credit cards is likely to confirm that a potential borrower poses a high level of risk. On the other hand, credit problems resulting from high expenses related to a medical issue or closing a business may be seen as one-time events that do not reflect an accurate picture of a borrower's financial history.

Borrowers can also lower lender perceptions of risk with high monthly income relative to debt payments or enough cash on hand to cover expenses for four to six months. The key is to be able to show facts that can isolate negative credit events in the past, and to provide a stable financial picture in the present.

Key Points

Much of the decision-making process for lenders in the mortgage approval process relates to the level of risk presented by borrowers, much of which is represented by credit scores. By minimizing risks for lenders, either with an FHA-insured mortgage or a plan that includes a larger down payment, a detailed description of isolated credit events or evidence of financial stability, borrowers with low credit scores can still pursue their dreams of home ownership.