Buying a house is absolutely possible with bad credit, but it is harder and more expensive than it would be for people with excellent credit. Before starting the homebuying process, you should consider why you want to be a homeowner. Homeownership has many large, unexpected costs that can be difficult to cover if your financial situation is unstable. Continuing to rent indefinitely or until your credit improves may be the best financial choice for you.
- Try to improve your credit score as much as possible before shopping
- Consider all of the upfront and long-term costs of an FHA Loan before signing on to one.
- Attempt to improve your overall financial situation as much as possible to improve your odds of getting approved for a conventional loan.
FHA Loans—Your Loan Option for Bad Credit
Federal Housing Administration (FHA) loans are loans insured by the FHA, but are actually issued by any FHA-approved lender. FHA loans were created to help low and moderate-income borrowers become homeowners. If individuals cannot get approved for conventional mortgages, then FHA loans are the remaining option for hopeful home buyers with bad credit.
FHA Loan Requirements
- Credit score as low as 500 with 10% down or as low as 580 with 3.5% down.
- Debt-to-income ratio of 43% or less
- Verifiable income for 2+ years
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau (CFPB) or with the U.S. Department of Housing and Urban Development (HUD).
Improve Your Credit Score
Taking a few steps to improve your credit score before home shopping will improve your home buying experience exponentially. In today's hot real estate market many home sellers are less likely to choose offers with low down payments that will require them to deal with FHA's stringent appraisal process. Improving your credit score can allow you to get a conventional mortgage and make stronger offers on homes that are more likely to be accepted.
- Pull your credit report to see why your credit is low and check for errors. This is free to do once a year from Experian, Equifax, and TransUnion at AnnualCreditReport.com.
- Pay down any revolving credit lines to improve your credit utilization percentage. This usually results in an immediate jump in score.
- Have any errors removed from your credit report, especially late payments
- Consider consulting with a credit repair service to see if your score can be improved enough to save you the cost of their fees in reduced mortgage rates.
Why You Should Improve Your Credit Score Before Buying
Even improving your credit score by just a few points before buying can still save you thousands of dollars. If boosting your score allows you to be approved for a conventional mortgage instead of an FHA loan, you will save the upfront Mortgage Insurance Premium of 1.75% of the loan amount. Additionally, conventional loans tend to have lower closing costs and interest rates than FHA loans.
While both FHA loans and conventional loans will require monthly mortgage insurance if you put down less than 20%, an FHA loan includes monthly mortgage insurance for the life of the loan that you can only get rid of by refinancing—and paying closing costs on a new loan. For a conventional mortgage, the private mortgage insurance drops off once your loan balance is equal to 80% of the property value.
Optimize the Rest of Your Borrower Profile
Your credit score isn’t the only factor that goes into being approved for a loan. You can increase your likelihood of being approved for a loan under favorable terms even with bad credit by optimizing the other parts of your borrower profile.
Putting more money down on your mortgage essentially means that you are putting more of your own collateral into the loan and makes the lender view you as less likely to default and a lower-risk borrower. If you are struggling to come up with down payment money, there are many unique ways to beef up your funds. Some areas even have down payment assistance programs.
Improving your debt-to-income (DTI) ratio can also help you get approved for a mortgage with bad credit. If you can pay off or get rid of some of your monthly debt obligations like a car loan, your DTI will improve. Increasing your income by picking up a second job will also improve your DTI. The easiest way to improve your DTI is by shopping for homes at the lower end of your budget. If you determine that you can afford a house up to $300,000, but your credit score is still lower than you would like, you can increase your odds of being approved for a mortgage if you choose a house that costs $250,000.
Loan Options for Unique Populations
If you meet certain criteria, you may qualify for a VA loan or a USDA loan. Both of these loan types allow you to put 0% down without paying private mortgage insurance and do not require a minimum credit score, which makes them a much cheaper option than FHA loans.
You typically have to be a veteran who served for certain time periods or under specific circumstances or be a surviving spouse of a veteran with specific circumstances. VA loans are issued by private lenders but backed by the VA. You must have a Certificate of Eligibility from the VA to get a VA loan.
These loans are typically in areas designated as rural by the USDA and borrowers must meet income eligibility limits based on the median income of their county and their household size.
Is It Harder to Get a Mortgage with Bad Credit?
Yes. Bad credit makes it harder to get a mortgage. Fewer lenders offer FHA loans than conventional ones.
Can I Get a Conventional Mortgage if I Don't Have 20% Down?
Yes. You can get a conventional mortgage with as little as 3% down, provided you meet the rest of the lender's requirements for credit score, income history, and debt-to-income ratio.
Should I Pay for Credit Repair Before I Go Home Shopping?
Try to get an estimate from the credit repair service of how many points they can improve your score by and how much their service will cost in total. If they can improve your score enough to qualify for a non-FHA mortgage, then you will save 1.75% in upfront mortgage insurance premiums ($1,750 per $100,000 of house), which will probably offset the cost of the credit repair service. You may be able to improve your credit score yourself, so do your due diligence.
The Bottom Line
While it is possible to buy a home with bad credit, it may not be the best choice. FHA loans are a great tool for borrowers but changes to the program after the subprime mortgage crisis make them a very expensive loan product. Prospective borrowers should run the math to see how much improving their credit and having more money to put down could save them before rushing into the home buying process.