How to Get a Mortgage with Bad Credit

There’s a saying borrowed from an old blues song about luck. If not for bad luck, the sad reminder goes, there’d be no luck at all.

It’s a proverb with a broad application, though it wouldn’t be a surprise if people trying to get a mortgage with bad credit claim it as their own. In the housing market, having bad credit might even be worse than having no credit at all.

But the encouraging news is that buyers with bad credit scores aren’t precluded from qualifying for a mortgage if they utilize sound strategies and know what to expect from the process of securing a loan in an ever-changing market.

“A cooling housing market could help buyers with bad credit who would not have been able to secure a mortgage previously, as lenders may be more willing to take risks when the market is soft,” Shaun Martin, owner and CEO of The Home Buying Company, said.

“However, it is important to note that if there are multiple competitive bids for a property, buyers with bad credit may still not be able to compete. Therefore, it is important to find the right lender who can offer the most suitable loan terms and take into consideration a buyer’s specific situation.”

A Consumer Protection Financial Bureau survey revealed that since 2018 lenders have made more loans available to buyers with below-average credit scores. Those buyers often need a higher down payment or will pay a higher interest rate to secure that loan.

Is it worth it? Buying a house is one of the more important steps consumers can take in building wealth. Buying a house with bad credit is possible if you take the time to learn about loan options and understand how rebuilding a damaged credit score can better position you in a competitive market.

How Low of a Credit Score Can You Have to Get a Mortgage?

Qualifying for a mortgage with bad credit isn’t as cut-and-dried as those signs in amusement parks: “You Must Be This Tall To Ride.”

There’s no definitive minimum credit score that automatically disqualifies prospective buyers, though the equivalent of a trap door that can send your chances plummeting is a credit score below 600.

FICO scores on completed purchases from Ellie Mae, Inc. show that perfect credit is rare and even bad credit doesn’t rule borrowers out of the housing market:

• 9% of homebuyers had a pristine credit score of 800 or above.
• 1% had a score of 750-799.
• 32% had a score of 700-749.
• 43% had a score of 650-699.
• 77% had a score of 600-649
• .040% had a score below 600.

People with less than average credit scores secure home loans every day. But credit score is a crucial factor in the loan terms a buyer can expect. Some lenders specifically make loans for bad credit available but those may only make sense in certain circumstances.

Home Loan Options for Borrowers with Poor Credit

If your credit score is below 600, it might be in your best interest to dedicate yourself to rebuilding your score before you try to secure a loan. Nonprofit credit counseling can help with that.

Whether you qualify for a loan is often determined by each borrower’s circumstances. How much of a down payment you bring to the table, your credit history, whether you can bring a co-signer into the mortgage application are all factors lenders take into account.

Depending on those circumstances, the appropriate entries into the housing market are:

1. Conventional loans
2. FHA Mortgage
3. USDA Loans
4. VA Loans

Conventional Loans

Freddie Mac (660) and Fannie Mae (620), two of the largest lenders of conventional loans, apply fairly strict credit score minimums to borrowers making the minimum down payment of 3%. The minimum credit score for conventional loans is 620.

Are there exceptions? Yes. For instance, some lenders might see borrowers with a lean credit history as viable candidates if they have substantial income and no red flags on their report. And under certain circumstances loans for bad credit are an option.

“It’s important for borrowers with no credit history to put their best foot forward and demonstrate that they can manage a loan responsibly,” Martin said. “This can be done by providing proof of income, making regular payments on other debts, and having a solid down payment ready.”

FHA Mortgage

FHA loans, offered by private banks but backed by the government, can be a lifeline for those buyers who don’t qualify for a conventional loan. In 2019, one in five buyers had an FHA loan on their home.

The minimum credit score for a FHA loan is 500.  A credit score of 580 requires a 3.5% down payment. While you can get an FHA loan with a lower credit score, nearly 80% of FHA loans go to borrowers with credit scores of 650 or higher.

USDA Loans

USDA loans are subsidized by the U.S. Department of Agriculture and are earmarked for low to moderate income individuals living in rural areas or low-density suburbs. They don’t require down payments and carry a minimum credit score of 580.

VA Loans

The Department of Veterans Affairs operates the VA loan program. Like USDA loans, VA loans require no down payment and the minimum credit score is 580.

FHA loans without a 20% down payment require the borrower to carry private mortgage insurance (PMI) and some closing costs are waived for VA loan borrowers.

The VA home loan program is only available to veterans and active service members.

What To Do If You Can’t Get a Mortgage

 You need a better strategy than playing the lottery. If you have poor credit, there are steps to take to help qualify for a loan:

Larger Down Payment

A down payment reduces risk for the lender. You have skin in the game. They have a buffer. An excellent figure is 20% of the purchase price, which allows you to avoid private mortgage insurance (PMI).

Cash Reserves

Even with a large down payment, it’s helpful to have ample cash reserves on hand. Cash reserves tell lenders you can absorb the unexpected, such as a failing hot-water heater or a hefty medical expense.

Rent History

Be able to verify that you’ve paid your rent on time consistently for 12 to 24 months. FICO estimates that less than 1% of credit files contain rental entries, so it pays to investigate alternative credit reporting tools.

An example: Rent Reporters (one-time enrollment fee of $94.95, then $9.95 per month $7.95 if you go annually), reports to TransUnion credit bureau). Terms offered by others, such as Rental Kharma, RentTrack, ClearNow,  PayYourRent ERentPayment, are readily available online. RentTrack and ERentPayment report to all three credit bureaus.

If you opt-in to a service, make sure to pin down the total costs for the year and ask how your personal data is protected. Also, ask about free access to credit scores, how soon rent information will appear on your report and the cancellation process.

Explain Your Circumstances

It’s helpful to write a letter that explains the borrower’s circumstance while injecting some personality. Write as if you’re trying to win the lender over. You are.

Account for each negative item on your report, even if it seems dated or insignificant. Explain why this problem won’t happen again.

If there’s a medical issue, get documentation from the doctor or include the bills. If you were laid off, include a copy of the termination letter or evidence of unemployment benefits. If there was no medical insurance, include proof that you have it now.

If real estate is location, location, location, the key to the loan process with bad credit is to document, document, document.

Should You Take Out a Mortgage or Increase Your Credit Score?

So how badly do you want that house? Or, better yet, how badly do you need that house?

Because over time you can take steps to increase your credit score by 100 points. Two important first steps in how to establish credit are:

• Start making on-time payments every month
• Stop using your credit cards until you paid them all off

“Generally, it can take anywhere from six months to two years to build a good credit history,” Jon Sanborn, co-founder of San Diego-based SD House Guys, said. “Various factors such as timely payment, debt level and types of accounts held all play a role in how quickly someone’s credit score improves.”

Paying on time accounts for 35% of your credit score. Credit utilization – how much of your available credit you use every month – accounts for another 30%.

If you are on time with at least the minimum payment (preferably more) every month and use cash or checks to pay all bills (except in emergencies), you are taking positive steps to address the factors that determine your credit score.

Is it easy? No, but it’s certainly doable if you really want that house at a payment level you can afford for the next 15-30 years.

Learning how to improve your credit score is the single most important step you can take.

Bad Credit Lenders

There are some mortgage loan choices for consumers with bad credit. Know your options.

Mortgage Brokers vs. Banks/Credit Unions

Mortgage brokers only account for approximately 10% of the origination market due to tighter regulations resulting in more in-house sales operations.

The SAFE Mortgage Licensing Act of 2008, ensured brokers must pass state licensing exams, proving they know the rules of financing. Federal regulations prohibit brokers from accepting premiums from lenders in exchange for steering customers into higher-priced loans.

Mortgage brokers are middlemen who represent many lenders and various loan products. The broker tries to match the loan product that best meets your needs at the best possible price. Once approved, borrowers generally deal with the loan originator or their mortgage service provider.

Banks, mortgage banks and credit unions are considered direct lenders. Employees of that institution review applications and decide whether to issue loans. Typically, banks sell loans on the secondary market a few months after closing.

Benefits of Working with a Mortgage Broker

Mortgage brokers work with many different lenders to find loans for clients, but don’t give loans directly. What a broker can offer that a bank can’t: variety.

If a borrower has a low credit score and isn’t certain to obtain a loan, brokers with lots of contacts could find a deal.

Downside? Brokers sometimes attempt to increase their profit by writing hidden costs into your loan. You must be educated about the process and ask questions.

Benefits of a Bank or Credit Union

The best deals can usually be found through a direct lender, simply because there aren’t many add-on fees or middlemen who touch the loan and get paid for it.

Direct lenders are in the volume business, so they can cut costs. Employees usually don’t get a commission, just an hourly rate, so they aren’t looking to create extra charges. They lend out their own money, so cash is made through the servicing of a loan, not through charging origination fees.

If a borrower fits the bank’s criteria – job stability, long-time resident, and good income — the loan is practically automatic. Money is made by processing a cookie-cutter type of loan — without extra work or effort.

Downside? Direct lenders offer only their own programs and there’s no comparison shopping. They may have higher credit score requirements.

Online Lenders

Can I get a mortgage online?

If you can get groceries or a new set of steak knives online, why not a loan from an online mortgage lender?

SoFi, Prosper, Lending Tree, Wells Fargo and others offer mortgage services online. Once considered questionable, online mortgages are now mainstream.

Al Bowman, president of Mortgage Commentary Services in Tampa, says internet lenders have not only become increasingly competitive but offer unmatched convenience.

“Who wants to gather pages of documents to go down to a brick-and-mortar office during business hours when they can accomplish the same thing sitting at a computer at 2 a.m., noon or 11 p.m., if they prefer?” Bowman said. “They are certainly viable options and should be considered by anyone looking to finance or refinance a home.’’

Shopping Around for a Mortgage

Why not comparison shop between brokers and banks. There might be some excellent online options available as well.

Make a spreadsheet with three or four mortgage sources, keeping track of interest rates (which change constantly), lock-in fees and points. Don’t forget closing costs, additional fees and whether there is a prepayment penalty.

With brokers, ask how they’re compensated (it’s usually 1% to 2.5% of the loan amount) and whether they’re paid by the borrower or lender. Brokers are required to disclose their fees upfront and they can’t earn more than the disclosed amount.

Look for brokers who ask questions, instead of simply quoting their rates.

Ask friends and family members for suggestions, especially if they recently obtained a loan.

Check credentials. Mortgage bankers are regulated by either your state’s department of banking or division of real estate. Mortgage brokers, if not regulated by your state, can be checked through the National Association of Mortgage Brokers or the Better Business Bureau.

There are good options online with attractive deals, but make certain you are dealing with a reliable broker or lender.

Which Lender Type Is Best for Bad Credit Borrowers

Mortgage loans aren’t one-size-fits-all. But here are some general profiles of a borrower, along with the recommended route to a loan:

• Excellent credit, easy access to financial documents, long-time employee of one company: Online lender or bank.
• Self-employed borrower who doesn’t want to share data about income or assets with a mortgage provider: Mortgage broker.
• Repeat home shopper, rate-and-term refinance customer, financially savvy: Online lender.
• Adjustable-rate shopper, relationship customer with many accounts and one institution: Bank
• Convenience shopper who wants the easiest loan to get, even if it’s more costly: Home builder or real-estate agency lender.

Mortgage Underwriting: Manual or Automatic?

Lenders use mortgage underwriting to determine if a borrower qualifies for a loan. The process usually follows the “three C’s’’ of underwriting — credit, capacity and collateral.

There are two paths — manual and automatic.

Under manual underwriting, an assigned person reviews your application. That person reviews documents such as credit score, debt-to-income ratio, bank statements and pay stubs, then decides on your ability to repay. If the underwriter is satisfied, your loan application is approved.

Automatic underwriting is a computer-generated decision based on logic and algorithms. It gives a near-instantaneous loan approval or denial based on relevant data such as credit history. Some factors, such as income and assets, must be verified. Occasionally, applications might be referred to manual underwriting, which can require up to 60 days.

Manual or automatic: which is the better choice?

Manual Underwriting

If you have bad credit or a complicated financial situation, the best choice might be manual underwriting. A computerized data-driven approval program might quickly decline the application. Manual underwriting is cumbersome and time-consuming, but probably the better option for borrowers who don’t fit a standard mold.

Certain scenarios might be quickly rejected by automatic underwriting, thus begging for a manual review:

• Debt-Free Lifestyle: Great credit scores reflect a history of borrowing and repaying loans. If you are just starting out or have no interest costs, your credit evaporates. It’s not bad credit. It’s simply no credit. Being short on credit is best interpreted with a human touch because it’s possible to get a loan with no FICO score through manual underwriting. Having no credit is always better than having things like debt settlement or bankruptcy in your credit report.
• Recent Financial Problems: Manual underwriting provides more loan options after a bankruptcy or foreclosure.
• Low Debt-to-Income Ratios: It’s always good to keep your spending below your income. Manual underwriting allows you to go higher, but be careful not to stretch too far and buy an expensive property that could make you “house poor’’ (spending a large portion of your total income on your home and its upkeep).

Know that the manual underwriting approval process can be frustrating and monotonous. It’s helpful to identify at least four on-time regular payments you’ve been making for at least the last year. Shop around. Don’t give up after the first negative response. Generally, the idea is to show that the loan won’t be a burden and you can afford to repay.

There are “compensating factors” that should help your application:

• Having liquid assets that cover your mortgage payments for 3-6 months.
• Having your monthly payment not exceed your current housing expense by more than 5% or $100.
• No discretionary debt.
• Additional income. Automatic underwriting doesn’t count overtime, seasonal earnings and other items that could add to your income. It can be reflected through manual underwriting as long as it’s documented and expected to continue.

Automatic Underwriting

Automatic underwriting carries several advantages:

• From application to approval to closing, the process could take as little as two business days to a week.
• Closing costs are reduced.
• Borrowers who weren’t previously approved are helped by a higher debt-to-income ratio allowance.
• There’s no threat of personal prejudice.
• Loan products can be tailored to the borrower.

The downside? Home loan turnover has tripled. Because the credit score is so important, sometimes the ability of a borrower to repay is overrated and it leads to more defaults that harm the mortgage industry.

Subprime Mortgages: Pros and Cons

Subprime mortgages are loans granted to borrowers with low credit scores (usually below 600), who would otherwise not be approved. Because of the risk assumed by lenders, these mortgages come with high interest rates.

Volatile adjustable-rate subprime mortgages — with initial low rates, then a jump to higher figures — were common in the real estate meltdown of 2007.

Economists blamed them in part for the downturn in the economy. A regimented era followed. Many lenders refused to give a mortgage to anyone with a credit score less than 680.

Everyone’s situation is different, but subprime mortgages come with pros and cons.

Pros:

• People with low credit scores can own a home without years of trying to establish better credit. That type of activity would stimulate the economy.
• Subprime loans can actually help borrowers fix their credit scores. Borrowers can use it to pay off other debts and then work toward making timely payments on the mortgage.
• It’s relatively easy to be approved. Borrowers can obtain money, even if they have defaulted on past loans or have outstanding debt.

Cons:

• Closing costs and fees are higher than normal. Of course, the lender wants as much money upfront as possible because there’s a higher risk of default.
• Borrowers might not need an average or better credit score, but they must show they have sufficient income to make the monthly mortgage payments.
• Higher interest rates, of course. If good credit could have the borrower qualifying for rates less than 4%, as an example, a subprime mortgage rate might be 8%-10%. What does that mean? If you have a 30-year mortgage at 4% interest to borrow $100,000, the repayment on normal time will be $171,870. With 10% interest, the repayment balloons to $315,926.

Predatory Mortgage Loans

It’s important to follow your instincts. If something doesn’t seem right — beware! — you might be dealing with a predatory mortgage loan company.

There are several warning signs. Realtors or lending officers have done things like inflate closing costs or interest rates; target seniors or minorities not familiar with the system; promise to refinance later; or, the worst one, steer you to a specific lender with promises you’ll get the best deal there.

Just know that not everyone has your best interests in mind. Get everything in writing and, if you can’t afford a lawyer, at least have someone you trust look things over before you finalize a deal.

Find Help Getting a Mortgage and Buying a Home

Unless you bought your spouse a yacht for Christmas, buying a home is probably the single biggest financial decision you’ll make in a lifetime. It’s the surest way to build wealth in America, which makes the terms of the loan you secure so critical to your long-range economic health.

Getting a mortgage with bad credit is only half the challenge, which is why mortgage counseling is such a valuable tool for many borrowers trying to navigate the housing market while also struggling with credit card debts and/or higher interest loans.

Mortgage counseling can help people get their finances together before they buy a home and also help people who’ve bought a home and are searching for ways to free up some money to pay off other debt.

The rest of the challenge beyond securing a mortgage with bad credit is knowing how to budget for that hefty payment you’ve inherited and keeping current with payments that allow you to build equity and maybe even a savings account.

Credit counseling can help in myriad ways. Credit counselors can advise you on money management and other basics of finance. They can help settle debt with your creditors and devise a payment plan that addresses the causes of debt while planning for a less stressful future,

Perhaps most importantly, credit counselors can help you rebuild your credit score with proven strategies that lead to securing a more affordable interest rate on a home loan or a refinancing.

Having bad credit in the housing market and elsewhere is a challenge but it doesn’t have to be a roadblock.