You may have found your dream home, saved up for a down payment and budgeted to ensure you can afford the mortgage payment. However, your credit is less than perfect.
You still have options. Find out how your credit affects your borrowing power and learn about some of the best home loans you can get with a lower credit score.
What does your credit score mean?
Your credit score is a number that reflects your creditworthiness. Banks, credit unions and other financial institutions use your credit score to determine your risk level as a borrower. To calculate your credit score, credit bureaus use formulas that weigh factors like:
- How many loan and credit card accounts you have and the remaining balances
- The age of your loan and credit card accounts
- If you pay your bills on time
- How much debt you have
- The number of times you've recently requested more credit
It's easy to assume that you have just one credit score, but that isn't the case. In fact, several organizations have their own credit scoring models. Lenders may rely on one or more to assess your creditworthiness, but mortgage lenders typically use the Fair Isaac Corporation (FICO) model.
Lenders use credit scores to determine which home loans borrowers qualify for. In most cases, borrowers with a high credit score are eligible for home loans with lower interest rates and more favorable terms.
Home loans for borrowers with low credit scores
If you have a lower credit score, you may not qualify for a Conventional home loan. Instead, you might need to consider one of these mortgage options.
1. FHA loans
The U.S. Federal Housing Administration (FHA) offers government-backed home loans with more lenient terms. FHA loans typically require a fair credit score of 580 or higher. However, you don't have to make a large down payment. Instead, the minimum down payment for an FHA loan is 3.5% of the purchase price. Some lenders may offer FHA loans with a score of at least 500, or if you have no score but can establish a non-traditional credit history, a loan with a down payment of 10%.
To offset the risk that borrowers with low credit scores can bring, FHA loans require a mortgage insurance premium (MIP). The upfront MIP is 1.75% of the loan amount, while the annual MIP is between 0.45% and 1.05% of the average remaining mortgage balance and is usually included with your monthly mortgage payment. Contact your Home Lending Advisor for current information.
2. VA loans
If you're an active, detached, retired and/or disabled member of the military, including the National Guard or Reserves, you could qualify for a U.S. Department of Veterans Affairs (VA). VA loans generally don't require a down payment. You typically need a credit score in the fair range to qualify
Like FHA loans, VA loans come with additional fees. Most borrowers have to pay a one-time funding fee between 1.4% and 3.6% of the loan amount. Check with your HLA for current information. Borrowers who make larger down payments and who are applying for their first VA loan typically pay the lowest funding fees.
3. Grant programs
Many state, county and city government agencies offer grants, vouchers and other programs to assist borrowers with low credit scores. Check for local mortgage grants and housing assistance programs in your area.
What's considered a high credit score?
Lenders typically consider FICO credit scores between 670 and 739 to be good, according to the Consumer Financial Protection Bureau (PDF). FICO credit scores between 740 and 799 are usually deemed very good, while FICO credit scores above 800 are considered exceptional.
What's considered a low credit score?
Lenders generally consider FICO credit scores between 580 and 669 to be fair. Credit scores below 580 are deemed poor.
What other factors do lenders review?
Your credit score is an important part of your loan application, but it isn't the only factor that lenders consider. They also review:
- Income and debts: Most conventional lenders require a DTI of 43% or less. To determine your DTI, lenders divide your mortgage payment and recurring monthly debts by your monthly pretax income.
- Down payment: The larger your down payment, the better chance a lender will consider your application. While there are low down payment options at least a 20% down payment will also help you avoid paying private mortgage insurance. You can calculate this percentage by dividing your down payment by the lesser of the appraised value or purchase price.
- Assets: In some cases, lenders require you to have assets in reserve after closing on your loan so you can continue making your monthly mortgage payments. Most bank accounts, stocks and bonds count as assets.
- Work history: Most lenders prefer borrowers with steady employment. They may require you to have been on your current job or in your current job field for at least two years.
What to consider when applying for a home loan with a low credit score
If you do apply for a home loan with a lower credit score, make sure you consider these factors:
- You won't permanently damage your credit score. A home loan application shows as a hard credit pull on your credit report. This credit pull may affect your credit score.
- You can lock in a low interest rate. If you want to buy a house when interest rates are particularly low, acting sooner rather than later may be a smart idea. Waiting longer to apply could mean getting a loan when interest rates and monthly payments are higher.
- You may need a large down payment. To offset your credit score, lenders may require compensating factors such as a down payment of 20% or more of the purchase price.
- Your lender may have stricter income or asset requirements. To make up for a low credit score, your lender may require a lower DTI ratio or significant assets in reserve.
- You may end up spending more. Some low-credit score loan options require high upfront or annual payments, which can increase the cost of buying a house.
How to improve your credit score
Even if your credit score is low now, it doesn't have to stay that way. Use these tips to improve your credit score:
- Make loan and bill payments on time. Start by paying every bill by its due date. Over time, your good payment history can increase your credit score.
- Pay down debt. If you have significant credit card balances or other debt, paying it down can increase your credit score. You can follow the snowball method, which involves paying off your smallest balances first. Alternatively, you can try the avalanche method, which involves paying off high-interest balances first.
- Keep older accounts open. After paying off a credit card, resist the temptation to close the account. Keeping older accounts open gives you a longer credit history and lower credit utilization ratio, both of which can improve your credit score.
- Stop applying for credit. Multiple hard credit pulls can lower your credit score. When every point counts, avoid applying for credit.
- Correct credit report errors. Credit reports can contain mistakes that can lower your score. Start by checking your credit score for free and reviewing your report for mistakes. Contact the credit bureaus directly to dispute errors.
Just because your credit score is less than perfect doesn't mean you can never get a mortgage. Speak to a Home Lending Advisor to find out which home loans you're eligible for and work together to decide whether you should apply for a mortgage now or wait until your credit score is higher.