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When mortgage rates fall, it’s possible as a first-time home buyer to qualify for a bigger mortgage and more expensive house.
But what if you have poor credit?
Can you buy a house with bad credit today – or should you work on improving your credit first?
Sometimes it makes sense to buy a house right now, even if you have bad credit. Here are three reasons to consider this:
Researchers at Harvard University’s Joint Center for Housing Studies have found repeatedly that homeownership is the most reliable way for households to accumulate wealth. That’s especially true for less-affluent households.
Buying a home and paying down a mortgage can even help you improve your credit history and credit score with credit-reporting agencies. And eventually, you may be able to refinance your mortgage to a lower interest rate and reduce your monthly payment. That can free up income to pay off debt, accumulate savings and enhance your financial security.
If you have difficulty paying your home loan, however, this could start a financial landslide from which you won’t easily recover. You might end up in foreclosure and lose all of your home equity.
A bad mortgage loan payment history can wreck your credit score. Bankruptcy might be in your future, impacting your financial reputation and possibly even your ability to get a job for many years. For this reason, you should avoid jumping into homeownership if affordability is a concern.
See how you would answer these questions:
If so, you might not be able to reliably make a mortgage payment.
If you plan to buy a home with a low credit score, proceed with caution.
Avoid taking on a monthly payment that significantly exceeds what you currently spend on housing. Understand that homeownership comes with additional costs like repairs and maintenance, and make sure you can handle them.
How do you know if buying a house with bad credit is a good idea?
You need to evaluate the urgency of homeownership right now and make sure you can handle a mortgage. Work through this list of questions:
Most of these questions are not specific to people with bad credit – even consumers with good credit should avoid unaffordable home purchases.
If you decide to apply for a home loan with a poor credit score, some programs will work better than others. Here’s a quick run-down of common bad-credit mortgage options:
FHA loans are available to borrowers with credit scores as low as 580 with 3.5% down and as low as 500 with 10% down.
However, few applicants with scores this low get mortgages. The average FICO score for FHA home loan purchases in May 2020 was 692, according to mortgage tracker Ellie Mae.
If you are a service member or veteran eligible for VA financing, you may borrow with no down payment. There is no “official” minimum credit score, but many lenders impose a 620 minimum. And you have to show that you are managing your debt responsibly.
USDA “rural housing” loans also require no down payment. In most cases, the minimum FICO score is 640, a “fair” credit score. Homes must be located outside major population centers.
Non-prime mortgage lenders make their own rules because they lend their own money. Expect to pay higher interest rates for these loans, which may allow borrowers with FICO scores as low as 500.
These loans come from private investors or groups and they can be very expensive. Expect to make a large down payment and pay several points (each “point” is 1% of the loan amount) up front. These lenders set restrictive guidelines and high rates and fees, so they won’t lose money if you default on the loan.
Many home loan programs allow a low credit score. Some permit a high debt-to-income (DTI) ratio, with over 43% of your income going to monthly payments for mortgage and other debt payments. Others allow a small down payment.
However, don’t expect to secure home loan approval with a low credit score and a small down payment and a high DTI. That’s called “risk-layering” in the home loan industry, and mainstream mortgage lenders today won’t allow it.
To increase your chance of securing mortgage approval with a low credit score, apply for a loan that’s affordable – a loan that won’t increase your monthly housing expense by much and keeps your DTI low.
You could make a larger down payment or enlist the help of a co-borrower or co-signer.
Another option is to save a bigger emergency fund. If you have two to six months of mortgage payments in savings (called “reserves”), you reduce the lender’s risk significantly.
Finally, you can ask the home seller to help you with closing costs instead of negotiating a lower price. That can help you buy a lower interest rate, increase your down payment or retain more reserves.
Still wondering how to buy a home with bad credit? One strategy for mortgage success is practicing for homeownership.
This will make your mortgage application stronger and show you what your life will be like (how much you’ll have left for spending) with a mortgage. Make sure you’re comfortable with this before committing to any home loan.
One characteristic of some non-prime or private home loans is that they might allow high DTI ratios, which may increase your chances of ending up in foreclosure.
Some lenders allow you to pay out more than 50% of your gross (before-tax) income in mortgage and other debt payments, leaving you with less than half of your income for taxes, savings and all other living expenses.
To make sure that you’re not taking too much risk with a mortgage, run your numbers through the Money-Rates Home Affordability Calculator.
This cool tool helps you see what your maximum loan amount would be for any DTI you specify (DTI is called the “back-end” ratio on this calculator. The “front-end” ratio is your total housing payment (principal, interest, taxes and insurance) divided by your gross monthly income. The “back end” or DTI is your housing payment plus all other debts (credit card minimums, auto loans, student debt, etc.) divided by your gross monthly income.
The lower your DTI or back-end ratio, the more affordable your home loan – and the higher your odds of successful homeownership will be, regardless of your credit score.
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