Buying a home is exciting, but the sound of taking on hundreds of thousands of dollars in debt is just a little bit stressful.
And if you have bad credit? Well, then you’ll likely have double the stress.
Thankfully, there are several mortgage options out there offering flexibility when it comes to credit scores.
I spoke with three different mortgage lenders to get an idea of what’s considered bad credit, what types of loans to consider, and some tips for improving your score before you apply so you can save yourself some time and anxiety.
How do mortgage lenders define bad credit?
Each lender (and mortgage program) has its own cutoff for defining a bad credit score. Nishank Khanna, chief financial officer at Clarify Capital, explains:
“Anything under 670 can be considered a bad credit score when you’re hoping to purchase a house.
It becomes increasingly difficult to qualify for a competitive mortgage without needing a large down payment when you have a credit score below 580.”
The mortgage application process for bad credit
As Khanna mentions, there are several credit-related factors that also impact the mortgage application process.
While your application paperwork won’t differ, you may need some additional funds and exhibits to help get qualified.
Here are the extras you’ll need when navigating the mortgage process:
1. Down payment and cash reserves
For instance, you may need to increase your down payment amount in order to get approved. The loan amount you can apply for may also be limited if your credit is low because of high debt levels.
Lenders compare your debt and income (called your debt-to-income ratio) to determine your maximum loan size.
Finally, you may need to have more cash reserves in your savings to strengthen your mortgage application.
Get a sense of what you’ll need for a down payment with MU30’s mortgage calculator below:
2. Letter of explanation
Another additional aspect of the mortgage application with bad credit is a letter of explanation. This gives you a chance to address the negative items on your credit report, such as late payments or any loan defaults.
You’ll need to explain why each incident occurred, as well as why you don’t foresee the same problem occurring again.
Disqualifying factors for a mortgage
There are a few potential deal-breakers that can disqualify you from getting approved for a mortgage because of your credit score.
Your score is very low
Each lender has its own credit score cutoff for each loan program. So, while the guaranteeing entity may allow for a low credit score, your application may be declined if you don’t meet even that threshold.
Major negative credit entries
You may be disqualified if your credit report includes a bankruptcy, foreclosure, delinquent account, or account in collections. These obviously impact your credit score, but also send an additional red flag to lenders.
Pending credit disputes
If you’ve recently disputed an entry on your credit report, your application may be placed on hold until the issue gets resolved. This ensures the lender has an accurate picture of your credit history.
Debt too high
High amounts of debt hurt your credit score and your chances of getting approved for a home loan. Most lenders require a debt-to-income ratio of no more than 43% to 50%.
Lenders generally want to see you working in the same industry for at least the last two consecutive years. Your application could be denied if you’ve recently switched industries or had a gap in employment.
Types of home loans to consider if you have bad credit
You may not qualify for a conventional loan with bad credit, but there are other options to consider. Andrina Valdes, COO of Cornerstone Home Lending, Inc. says:
“Plenty of home loan programs exist with flexible credit requirements that are friendly to first-time buyers or repeat buyers with less-than-desirable credit.”
Here are some options to consider:
An FHA loan technically doesn’t have a minimum credit score requirement, but if you have a score under 580, you’ll need to pay at least a 10% down payment.
On the other hand, with a 580 or higher, you can typically qualify with just a 3.5% down payment.
While FHA loans are guaranteed by the Federal Housing Administration, private lenders actually make the loans, and each one will have its own criteria.
Another option for homebuyers who have lower credit scores is a VA loan.
“VA loans don’t technically have a minimum requirement for a credit score, but many lenders begin the cut-off at 580,” explains Valdes.
You’ll also need to have eligible military experience in order to qualify, which includes veterans, active-duty service members, National Guard and Reserve members, and eligible surviving spouses. Plus, you don’t need to put any money down on your home purchase with a VA loan.
A USDA loan is backed by the U.S. Department of Agriculture and helps lower-income homebuyers purchase real estate in rural areas. Credit requirements are also more lenient, with some lenders approving applicants with a minimum 580 credit score.
Like VA loans, a USDA loan does not require any down payment, but you do have to meet certain income requirements. Additionally, the property you’re purchasing must be located in a designated rural area. The USDA has an address lookup feature that helps you check eligible addresses.
Freddie Mac Home Possible
This option is for lower-income first-time homebuyers and those who haven’t owned a home within the last three years. Home Possible comes with flexible credit requirements as low as 660 and is also an option for potential borrowers with no credit score at all.
In most areas, your income may not exceed 100% of the area median income (AMI). The minimum down payment is 3%.
Fannie Mae HomeReady
The HomeReady program from Fannie Mae allows for a credit score as low as 620. It’s open to both first-time and repeat homebuyers.
You can also get approved with just a 3% down payment! Like a Home Possible mortgage, the HomeReady has an income limit of 100% of the area median income.
A non-qualified mortgage doesn’t conform to certain consumer protections, which means that lenders can offer more flexible eligibility criteria for bad credit borrowers.
There are a couple of ways a non-qualified mortgage could increase your odds of approval. If you have a lot of debt, a non-QM mortgage could allow for a greater debt-to-income ratio. It could also allow for more erratic income, although they’ll still need to verify income and assets.
Additionally, a non-qualified mortgage could help you get approved even directly after a bankruptcy or foreclosure. With a qualified mortgage, you’re required to wait between two and seven years to get approved.
There are, of course, some downsides involved with non-QM loans. Interest rates are higher and you’ll also need a larger down payment. They’re also more difficult to find since most major lenders focus on qualified mortgages.
The long-term cost of a bad credit mortgage
When you do get approved for a mortgage with bad credit, your interest rate will be much higher than someone with a high score would receive.
With a typical 30-year mortgage, that higher mortgage rate can cost you a lot.
Here is a comparison of the total cost of the same home for borrowers with different credit profiles.
Let’s say the total mortgage is $250,000, and the loan term is 30 years.
FICO Score APR Monthly payment Total interest paid
620-639 4.18% $1,220 $189,066
640-659 3.634% $1,141 $160,902
660-679 3.204% $1,082 $139,417
680-699 2.99% $1,053 $128,958
700-759 2.813% $1,029 $120,427
760-850 2.591% $1,000 $109,882
With a credit score of 639 or less, you’ll notice the monthly payment is over $200 more than a borrower with good credit. Over the life of a 30-year mortgage, the lowest-credit borrower also ends up paying almost $80,000 more in interest.
Tips to improve your credit score
No matter what your timeline is for purchasing a home, there are some steps you can take to improve your credit score before applying for a mortgage. Some require more time, while others may be done fairly quickly.
Check your credit report
Be sure your credit score is accurate before applying for a mortgage.
“Get the free annual credit report you’re entitled to from annualcreditreport.com,” Valdes advises. “Use this to check for any errors or fraud that could be affecting your score without your knowledge.”
Pay your bills on time
The most effective way to improve your credit score over time is to pay all of your bills on time. Debt payments are typically reported to the credit bureaus if you’re more than 30 days late.
To get ahead of your bills, make sure that you have a solid budget and that you stick to it.
Pay your credit card balance before it’s due
If you are rolling your credit card balance over from month to month, it is time to form better habits.
“Credit utilization accounts for about 30% of your total credit score,” says Khanna. “Paying off your card ASAP, which can be done by transferring from your checking to your card after purchase, will ensure your balance remains low.”
Pay down high-interest debt
Revolving debt in particular (like those credit cards) is counted more strongly against you than something like a car payment — because there’s no firm pay-off date.
As you prepare to buy a home, start paying down your highest balances.
Avoid large purchases
Making a large purchase, whether it’s a new car loan or a personal loan, skews your credit profile and your debt-to-income ratio. Even if you’ve been pre-qualified by a lender, your loan offer could change if any of your finances shift.
Don’t open new credit card accounts
Applying for a credit card (whether you get approved or not), adds a new credit inquiry to your credit report. This hurts your credit score by five to 10 points and may be viewed as a red flag by the lender.
Request a rapid rescore
Requesting a rapid rescore can help you get even closer to your goal. As Julie Aragon, CEO and founder of the Aragon Lending Team, explains:
“Rapid rescoring is like fast tracking a credit score update. It allows a lender to initiate a request for an accelerated update of a consumer’s credit report in just a couple of days.”
Bad credit isn’t an automatic barrier to homeownership, especially if you understand what’s impacting your score. Once you figure out the things that may raise a red flag to lenders, you can start making the necessary changes to improve your score and get the best loan offer possible.