You’re tired of writing rent checks to your landlord each month. You’d rather buy a house and start building equity with each monthly mortgage payment. But what if you have bad credit? Can you still buy a home with a low FICO® credit score?
Maybe. But you’ll likely face two requirements:
- You’ll have to accept a higher interest rate.
- You might have to come up with a larger down payment.
What counts as a bad credit score? That depends. FICO credit scores range from a low of 300 to a perfect score of 850. Lenders consider scores of 740 or higher to be top ones. If your score is under 640, though, you might struggle to persuade lenders to loan you mortgage money.
Buying a home can be challenging. And, in 2018, the new tax code may impact the financial equation on how much house you can afford or whether you can afford a house.
Here are six tips to follow if you want to buy a house even if you have bad credit.
Step 1: Find out your credit score
It’s time to check up on your credit score. You can get your FICO credit score for free in a lot of places, including some banks and credit card companies.
Keep in mind you have three credit scores, one each from Equifax, Experian, and TransUnion, the major credit reporting agencies. It’s a good idea to find out all three.
Step 2: Check for errors on your credit report
Your credit score is calculated from credit data in your credit report. Think of your credit report as a history of how you’ve handled borrowed money. You might have errors on your credit report. If so, they could potentially hurt your credit score.
You can get a free copy credit of your credit report every 12 months from each credit reporting company. How? Go to AnnualCreditReport.com. You want to make sure your information is accurate and up to date.
If you find any errors, you can dispute them with the credit bureaus.
Step 3: Be willing to pay higher interest
You can still qualify for a mortgage with a lower credit score if you’re willing to pay higher interest rates. Lenders charge credit-challenged borrowers higher rates as a way to protect themselves. Lenders know that borrowers with low credit scores have a history of paying bills late or missing payments altogether.
A higher interest rate does equal a higher mortgage payment. Here’s a comparison between two rates:
Scenario: You take out a 30-year, fixed-rate mortgage loan of $200,000 with an interest rate of 3.77 percent.
Payment: Your monthly payment, not including property taxes or homeowners’ insurance, would be about $928.
Scenario: You take out that same mortgage but with an interest rate of 5 percent.
Payment: Your monthly payment, again not including taxes and insurance, would jump to about $1,073, or a difference of $145 a month or $1,740 a year.
Step 4: Apply for an FHA loan
Loans insured by the Federal Housing Administration, better known as FHA loans, come with lower credit requirements. You can qualify for an FHA-insured mortgage with a down payment requirement of just 3.5 percent of your home’s final purchase price if you have a FICO credit score of at least 580.
There are some catches here:
- First, FHA loans are insured by the Federal Housing Administration, but they are originated by traditional mortgage lenders.
- Even though lenders can originate FHA-insured loans for borrowers with credit scores as low as 500 doesn’t mean they have to. They can still require higher credit scores.
FHA loans also come with a financial penalty. With traditional mortgage loans, you can cancel your private mortgage insurance after building up enough equity. With FHA loans, you can’t eliminate private mortgage insurance throughout the entire life of your loan.
The added expense? The cost of private mortgage insurance varies depending on the size of your loan, but you can expect to pay about $40 to $83 a month for it on a mortgage of $100,000.
Step 5: Come up with a larger down payment
Lenders might be willing to take a chance on you if you come up with a larger down payment.
It’s possible today to get a mortgage with down payments of 3 percent or lower. But for those with bad credit, larger down payments can make the difference between an approval or a rejection.
The logic here is similar to why borrowers with bad credit are charged higher interest rates. Two things happen when you put down more money upfront:
- You show your lender that you are willing to take on more of the risk in a home loan.
- The lender believes you are less likely to walk away from a mortgage when you invest more of your own money into the purchase from the beginning.
If you can come up with a down payment of 20 percent or more on your home purchase, you’ll increase your odds of earning an approval even if your credit isn’t sparkling.
Step 6: Rebuild your credit
Your credit might be so bad that you can’t qualify for any mortgage today. If that’s the case, you might want to rebuild your credit before applying again for a loan.
Fortunately, doing this isn’t complicated. Here’s how to start:
- Pay all your bills on time every month to steadily build a new, better credit history.
- Pay down as much of your credit-card debt as possible. The lower your credit-card debt, the better it is for your FICO score.
Improving your credit score does take discipline, and it doesn’t happen quickly. But doing so before you apply for a loan might be the better approach.