buying a house with bad credit : In this article, we’ll go over the basics of buying a home if you have bad credit which may stop you from even getting started. We’ll also go over the best ways to prepare when you buy a home even with bad credit.
Can you buy a house with bad credit?
However, it is not impossible to purchase a home with poor credit. You’ll just need to invest a little more time in preparation before you start seriously house searching. As with everything in life, it depends on a variety of factors, including:
- How bad your credit is
- Your source of income/how much/how steady it is
- What other debts you have
- Whether lenders in your area are willing to work with you
Let’s delve deeper into some of these factors and see how you can utilize some of your strengths to overcome your weaknesses.
Steps for buying a home with bad credit
If you’re thinking about buying a house and have bad credit, following these steps will let you know where you stand and what you ought to do!
1. Pull your credit report
Obviously, the first step is to find out where you’re starting, and what credit score you have. You can get an official report from AnnualCreditReport.com, but a single one is typically free. This includes reports from all three main credit bureaus.
They all employ slightly different metrics to calculate your score, so you’ll likely get a different number each bureau, though they’ll likely fall into the same range.
You can also use services like CreditKarma to check your score more frequently and monitor how your score’s changing. CreditKarma uses Equifax and TransUnion scores. To help you determine your credit health, the various credit score ranges can be broken down into the following categories:
- Exceptional: 800-850
- Very good: 740-799
- Good: 670-739
- Fair: 580-669
- Poor: Under 580
You’ll have better interest rates if you get a score in the top two ranges rather than the bottom two. A score in the middle range is nearly average, so you may not get equal approval once you reach 670, but you’ll have more choices.
2. Prepare to pay higher mortgage interest
The lender will lower your interest rate by a few percentage points when your score is low, because he assumes it is more risky with a lower score. That may not seem like much difference, but they add up over the course of a mortgage.
Fortunately, even if your interest rate is high right now, that doesn’t mean you’re stuck with it for life. You can refinance at a lower interest rate in the future once your credit is better.
3. Pay off your other debt
Lenders are even more interested in your debt-to-income ratio than your credit score, since DTI simply compares your total monthly payments against your total monthly income. This allows lenders to get an idea of how much other debt you have and how much income you can devote to your remaining expenses.
Your DTI ratio can be calculated by adding up your monthly debt payments (credit card payments, student loans, car payments, etc.) in addition to any future mortgage payment you plan to make. Then divide it by your typical monthly income. Lenders prefer DTI ratios below 36%.
Before you pursue home ownership, if you have a big monthly burden of other debts, plan on paying them off first. Getting rid of those remaining debts looks good to lenders, will help keep your credit score up, and will let you lower your DTI.
4. Determine your budget
Make a realistic assessment of what you can afford before going house hunting to prevent becoming “house poor”, which is what it means when you over spend on your mortgage/home expenses leaving little left to save, invest, or use for other expenses.
A good rule of thumb is to spend no more than 28% of your annual salary on a mortgage. For example, if you earn $50,000 per year, you’ll pay approximately $1150/month to a mortgage if you own a house with bad credit.
You should still factor in other home-related expenses, even if they don’t have to be included in this 28%. If you’re buying a fixer-upper because it’s cheap, find out what its necessary improvements will cost.
5. Save up a down payment
You’ll have an easier time getting a home loan with bad credit if you put down a sizable down payment. Being able to pay a down payment faster means getting a smaller loan and not accruing interest on the mortgage.
Loan-to-Value (LTV) ratio
This ratio compares the amount of your loan to the value of the home. If you are buying a $150,000 house and put down $30,000, your mortgage loan will be $120,000, $120,000 / $150,000 will give you an LTV of 80%.
Because lenders like low LTV ratios, they might charge you higher interest rates if you have an LTV above 80%. This is because you’re more likely to default on your loan if you don’t have much equity.
PMI (Private Mortgage Insurance)
Since you are considered higher-risk with a smaller down payment, you will also likely be required to pay PMI (private mortgage insurance). PMI protects the lender in case a borrower defaults on their loan.
Now, this doesn’t mean you have to have a 20% down payment. If you’re paying a lot in rent each month, then buying a home could still be better than renting. As long as you get approved, of course.
This story is just to show that saving 20% or more for a down payment is smart. It may take a while, but don’t get discouraged – just keep working hard and you’ll get there.
Once you reach your goal number for the down-payment, keep saving to keep a cushion. You should still have an emergency fund. That way you’re prepared for unexpected expenses and life circumstances.
6. Leverage an FHA loan
Federal Housing Administration (FHA) loans are designed to make homeownership accessible to people who may struggle to obtain a conventional loan.
An FHA loan is ideal for first-time home buyers, and typically requires lower down payments than a private lender. If your credit score is below 500, you must pay a 10% down payment to qualify.
This can definitely sound appealing, however, there are also drawbacks to getting an FHA loan. We discussed PMI above, and although it takes a different form with a federal loan, it is a similar concept.
- Upfront MIP: a one-time payment equaling 1.75% of your base loan amount. This can be paid upfront during closing or added on top of your loan.
- Annual MIP: recurring payments ranging from 0.45% to 1.05% of the base loan amount per year. The annual MIP is divided into 12 monthly payments each year, and you’ll pay it for 11 years or the life of the loan. As your loan balance goes down, your annual MIP also decreases since it’s charged as a percent.
If you put down $15,000, then your FHA loan amount is $135,000, and your upfront MIP is $2360. The first-year MIP could range from $600 to $1350 the more expensive the house and the smaller your down payment.
Other than the extra insurance costs and the requirement to work with an FHA approved lender, you will need to have a steady employment history for 2 years, buy a house under a certain price limit based on the cost of living in your area.
7. See if you qualify for a VA or USDA loan
You have two other types of credit-flexible loans available to you if you’re a veteran or a lower-income homeowner in a USDA-eligible rural area.
- Those who qualify for VA housing loans will receive competitive interest rates, government backing, and low or no down payment requirements. Credit score requirements vary by lender. However, lenders must not deny based only on credit alone.
- USDA loans: The United States Department of Agriculture (USDA) offers mortgage assistance to those who qualify with low to moderate income in rural areas. There’s no PMI, down payment, or credit-score requirements — lenders must examine other aspects of your financial history.
8. Improve your credit score
In other words, improving your credit score before you purchase a home is a good idea. Compared to the interest you pay over the life of a mortgage, the credit score you have makes a big difference.