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As we come out of the COVID-19 pandemic, record-low interest rates and pent-up demand have created a super-hot seller’s market for houses in 2022. The housing market is especially challenging for those with bad credit. Securing a home loan is usually harder when you have bad credit, but it’s not impossible—and there are things you can do to increase your chances of approval.
The minimum credit score needed to purchase a home can be anywhere from 580 to 640, depending on the type of mortgage. For example, a government-backed FHA loan has a minimum score requirement of around 580, while a conventional bank loan requires a score of around 620. If you’re in the market for something pricey, a Jumbo loan may require a score as high as 700.
In general, the higher your credit score, the better your chances of being approved with a decent interest rate. However, your credit is almost never the sole factor considered. The complexity of lending decisions may actually be good news for folks with bad credit, as it means their low credit score may not be an instant deal-breaker. Here are some steps you can take to improve your chances of being approved.
The most important step to improve your chances of being approved for a home loan is to increase the down payment. The down payment decreases the size of the loan, the monthly mortgage payment and the amount of money a bank could lose if you get foreclosed on. It also gives you instant equity in your property, providing the option to refinance or take out a home equity loan if financial troubles occur.
According to the National Association of Realtors, the median down payment in 2020 was 12 percent. However, individuals with bad credit may need to increase this to around 20 percent. According to the CFPB, this “20 percent threshold is based on guidelines set by Fannie Mae and Freddie Mac, government-sponsored companies that guarantee most of the mortgages made in the U.S.”
Mortgage programs such as FHA allow down payments as small as 3.5 percent for those with scores of 580 and above, but those with scores between 500 and 580 will likely need to provide higher down payments.
When you’ve reached your target credit score and saved up your down payment, you can apply for a mortgage. Getting preapproved prior to finding a house confirms that you’ll qualify for a mortgage and provides a target price range for your new house.
Remember to shop around and apply with multiple lenders. Preapproval will increase your likelihood of being approved and hopefully give you a few options to choose from in terms of down payment requirements, interest rates and so on.
Be sure to submit all your mortgage applications within a 14-day window, as this will minimize the impact of having multiple hard inquiries on your credit report.
A factor lenders consider when evaluating you for a new mortgage is your debt-to-income (DTI) ratio. This is your debt payment compared to your overall income, expressed as a percentage. You simply add up all your monthly debt payments and divide by your monthly gross salary.
Mortgage lenders calculate DTI to ensure there’s enough room in a person’s budget to comfortably afford their new mortgage payment. According to the CFPB, the general rule of thumb is that a person’s total debt payments shouldn’t exceed 36 percent of their monthly income. Some lenders may accept a DTI approaching 50 percent, but someone with poor credit may have trouble qualifying for these terms.
If you find yourself with poor credit and a high DTI, you may want to improve your debt-to-income ratio before applying for a mortgage. The best way is to pay down your existing debt by making more than your minimum payments, taking on a second job or reducing interest rates through debt consolidation.
To help more Americans achieve the dream of homeownership, several federal departments offer mortgage programs specifically targeted at individuals who might not qualify for a conventional private bank loan.
The FHA generally offers mortgages to individuals with a credit score of 580 and a down payment of around 3.5 percent. These loans are backed by the federal government, so banks are willing to take a little more risk when qualifying applicants.
Active and retired members of the military may qualify for loans backed by the Veterans Administration. This program is available to individuals with a credit score of around 580 and often requires only a small down payment.
This program is offered by the USDA and targets homes being purchased in rural areas by individuals with below-average incomes. A credit score of 640 gets automatic approval, and a manual approval can be used for scores down to 580. Down payment requirements are also small with this program.
Conventional nonconforming loans are those that aren’t backed by the government and don’t meet the Fannie Mae or Freddie Mac requirements for mortgages, such as specific credit score minimums. Some private lenders offer loan products to target specific niches, like those with poor credit. The standards required for these loans vary depending on the risk appetite of the lenders and their investors.
Individuals with low credit may find a private lender willing to approve their application, but consumers need to be careful when considering loan products in this segment of the mortgage industry.
If your credit is falling short of the 580 – 620 range required by most lenders, you likely need to take some of the following steps to improve your credit before applying for a mortgage.
In some cases, if you’ve taken a positive action for your credit and you want to see your updated score sooner than the 30 – 45 days it typically takes to update, you may want to ask your mortgage lender to help you initiate a rapid rescore. This may cost extra, but it could be beneficial if you’re on the cusp of qualifying for a mortgage and you’re just waiting to see a minor improvement to get you to where you need to be.
An individual with poor credit may be offered a mortgage at an interest rate that’s higher than the interest rate a person with good credit would receive. Small differences in interest rates can add up to major extra costs each month and over the life of a home loan.
For example, for a $300,000 house with a 3.5 percent down payment:
A home is the largest purchase you’ll likely ever make, so it’s important not to make a rushed decision. Sometimes it’s best to simply walk away, spend time improving your credit and try again later.
Credit reports can be complex, and having inaccurate negative credit can affect your life and cost you a lot of extra money in the long run, especially when it comes to mortgages. If you need help, Lexington Law offers a top-rated credit repair service that’s helped 77 percent of its customers increase their credit score by an average of 40 points over six months. Sign up today to get a free credit report consultation that includes your credit score, credit history and credit repair recommendations.