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Tips for First-Time Homebuyers with Bad Credit

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If you have bad credit, you don’t have to let it define you. And if you’ve made mistakes in the past that left you with a low credit score, or suffered from a life event such as an illness or divorce that resulted in financial distress, homeownership does not have to be out of reach.

Your credit score is just one factor among many that lenders review when approving a mortgage and estimating how much you can borrow. There are programs out there designed to help people with credit issues become homeowners.

Keep in mind that your credit score constantly changes, too. Improved money habits over time can raise your score and make it easier to become a homeowner.

Loan programs for first-time homebuyers with bad credit

Credit Score Required Down Payment Required Mortgage Insurance Fees/Fine Print
FHA loans 580 3.5% Yes, for entire loan term unless down payment is above 10% Upfront mortgage insurance of 1.75% in addition to ongoing mortgage insurance. Credit scores between 500 and 579 can be accepted with a 10% down payment.
Fannie Mae HomeReady program 620 3% Yes, but may be cancelled after 20% equity is reached Income limited to 100% of area median unless you buy in a low-income area.
Freddie Mac Home Possible program 660 3% Yes Income limited to 100% of area median unless you buy in a low-income area. Borrowers without a credit score may qualify with special underwriting procedure and 5% down payment.
USDA loans 640 Zero Yes, but typically lower than FHA and conventional Property must be located in eligible location. Borrowers must meet income qualifications for that area.
VA loans None Zero None Borrowers must be eligible veterans or military servicemembers. Borrowers must pay a funding fee.

Every loan program and lender has slightly different standards, so it pays to shop around for a loan. First-time homebuyers with bad credit may want to compare the benefits of these loan programs.

FHA loans: FHA loans are guaranteed by the Federal Housing Administration, which reduces risk for lenders. That means borrowers with a credit score of 580 or above may qualify for a mortgage with a low down payment requirement of 3.5%. Borrowers with a credit score of 500 to 579 may also qualify, but they need to make a down payment of at least 10%. FHA loans have the lowest minimum credit score requirements without income limits or a military service requirement.

VA loans: If you are in the military or served in the military in the past, a VA loan can be an excellent choice, especially if you have bad credit. The U.S. Department of Veterans Affairs guarantees VA loans to reduce risk for lenders. VA loans do not have a minimum credit score requirement. You will have to demonstrate that you can repay the loan, but you won’t have to pay mortgage insurance. Best of all, you won’t need to make a down payment. VA loans are a benefit to reward you for your service to the country.

USDA loans: The U.S. Department of Agriculture guarantees USDA loans, which means lenders are willing to take on a little more risk. These loans require a minimum credit score of 640, and you must meet income eligibility requirements. In addition, the home you want to buy must be in an area eligible for USDA loans. If you meet these requirements, a USDA loan is a good option because you won’t need to make a down payment.

Home Possible loans: If you have a credit score at 660 or above, the Home Possible mortgage program gives you the option to buy a house with a down payment as low as 3%. Home Possible loans are also an option for borrowers who don’t have a credit score at all due to not ever using credit in the past. However, you do need to meet income eligibility requirements to qualify unless you buy a home in an area targeted for revitalization.

HomeReady loans: HomeReady loans have a minimum credit score requirement of just 620, nearly as low as an FHA loan. In addition, you can make a down payment of just 3% and, unlike with FHA loans, your mortgage insurance can be cancelled after you reach 20% in home equity. However, your household income must be within the limits set by Fannie Mae, unless you buy a home in an area targeted for revitalization.

How first-time homebuyer programs can help

Buying your first home involves much more than just your credit score. A lender needs to know you have the means to make a down payment, pay closing costs and repay a mortgage. In addition to loans geared to first-time homebuyers, numerous programs are in place to provide prospective buyers with down payment assistance, closing cost help and tax credits. There are special buyer programs targeted to people in specific locations or professions that could also help you become a homeowner.

One resource that offers information on homebuyer programs in your area is the U.S. Department of Housing and Urban Development (HUD). HUD’s website provides search functions by geographical location so you can find local programs and learn more about whether you qualify for assistance. Many programs have income limits, and some require you to buy in a specific area targeted for economic improvement. Some financial aid is offered in the form of a grant, and some in the form of a second loan. Programs are available through local governments, nonprofit agencies and some employers.

Some first-time homebuyers are eligible for a mortgage credit certificate issued through programs administered by their state housing finance agency. According to the National Council of State Housing Agencies, eligible homebuyers can claim a dollar-for-dollar tax credit for a portion of the mortgage interest they pay, up to a maximum of $2,000. The remaining mortgage interest can be deducted as part of the homebuyer’s itemized deductions. You need to receive your mortgage credit certificate when you take out your mortgage, so be sure to discuss this option with your lender.

National programs for first-time homebuyers include the Good Neighbor Next Door program from HUD, which provides a 50% discount on home prices for properties in a community targeted for revitalization. The program is designed for teachers, emergency medical technicians, law enforcement officers and firefighters to buy in the area where they serve.

HUD’s Dollar Homes program works with local governments to help families with low and moderate income become homeowners while addressing community needs. Dollar Homes are foreclosures acquired by HUD that are being sold for $1 to qualified buyers who will make improvements to the property.

What to expect as a first-time homebuyer with bad credit

While bad credit may not necessarily stop you from buying your first home, it could make the process more difficult and more expensive. Here’s what you can expect:

  • You’ll face more scrutiny. Your credit score is meant to be an indication to lenders of the likelihood that you will repay your loan. Lenders will want to know why your credit score is low. If you have an explanation of an issue such as a period of unemployment or a past foreclosure that has a lingering impact on your score, that may be in your favor compared to someone with a history of overspending and chronic late payments without an explanation.
  • You may have to pay higher fees for your loan. Lenders have what are called “overlays,” which are additional fees or higher rates charged for borrowers with unusual circumstances, a lower credit score or who are buying a property that may be considered a risky investment.
  • You may have to pay a higher interest rate. Conventional loans that meet the standards set by Fannie Mae and Freddie Mac have “risk-based pricing,” which means the interest rate rises in incremental amounts depending on your credit score. Generally, the best mortgage rates are reserved for borrowers with a credit score in the mid-700s and above. For example, on myFICO.com, a calculator demonstrates that a borrower with a credit score of 760 or above might pay 4.01% for a mortgage, while a borrower with a credit score between 620 and 639 might pay 5.601%. One reason FHA loans are popular with borrowers with low credit scores is their rates stay the same regardless of your credit score.
  • You may have to pay higher mortgage insurance premiums. When you make a down payment of less than 20%, you must pay private mortgage insurance on a conventional loan. In addition to the lender’s loan approval, you’ll need the approval of a mortgage insurance company. Those private mortgage insurance rates vary according to your credit score, among other factors.

Tips for first-time homebuyers with bad credit

While first-time homebuyers with bad credit face more challenges than buyers with excellent credit, there are several steps you can take to demonstrate that you are a creditworthy borrower.

  1. Talk to a housing counselor. A HUD-approved housing counselor can help you prepare a budget for your home purchase, discuss available programs for homeownership assistance and education and offer tips to help you prepare for a loan application.
  2. Talk to a credit counselor. A nonprofit credit counselor can help you work through your credit issues, which will in turn improve your chances for a loan approval. For a small fee or for free, you can get help creating a budget and developing a plan to get out of debt.
  3. Review your credit report. You can request your free credit report from each of the three credit reporting bureaus (Equifax, Experian and Transunion) at annualcreditreport.com. Look for errors that need correcting and for negative factors on your report that could be lowering your score. The reports include instructions for correcting mistakes.
  4. Meet with a lender. Even if you’re not quite ready to apply for a loan, consulting a lender can be a good way to learn about loan programs and get individualized advice about what you need to do to qualify for a loan. You can ask a lender about possibly using on-time rent payments and utility bills to improve your credit profile.
  5. Pay all bills on time. One of the best ways to improve your credit score is to pay every bill on time. Your payment history represents 35% of your credit score, according to myFICO.com.
  6. Rebuild your credit history. Your credit profile includes past debt as well as applications for new credit. Keeping old credit accounts open with zero balances can help your credit score. Try to apply for new credit slowly so you don’t appear to be ready to take on too much new debt, especially as you near the time when you want to apply for a mortgage. You may also consider using a credit repair service.
  7. Pay down debt. Paying down the balance on credit card debt or eliminating other debt payments can help you prepare for homeownership in two ways. First, your credit score can be improved when you keep your credit card debt to less than 30% of your total credit limit. Second, your minimum monthly debt payments are part of your debt-to-income ratio, which compares your monthly payments with your gross income. Your ratio will be lower if you have less debt to repay.
  8. Increase your income. You can pay down debt and save money for your down payment faster if you can earn extra money with a side gig, or perhaps get overtime at your full-time job. Depending on how steady that income becomes, you may be able to use it to help you qualify for a mortgage. Some lenders are using new software for conventional loan applications that makes it easier for them to verify income from self-employment. A consistent job history is an important indicator of financial stability to lenders, so try to stay in a full-time job for a few years before applying for a loan, if possible.
  9. Make a larger down payment. A larger down payment can provide assurance to the lender that you’re less likely to default on the loan, as you own more of your home outright. In addition, your bigger down payment will make your monthly principal and interest payments lower, which could make it easier to qualify for a loan.
  10. Avoid payment shock. If you’ve consistently paid your rent on time and your new mortgage payment is similar to the amount you pay in rent, this could work in your favor. Lenders look at what they call “payment shock” to evaluate your ability to budget for your loan payment. For example, if your rent is $1,000 and your mortgage will be $1,200, that may be easy for you to adapt to, especially if you can demonstrate a consistent pattern of savings. If your mortgage would be $2,000, a lender may worry the payment jump will be difficult for you to handle.
  11. Consider a cosigner. If a family member is willing to cosign your loan, that could put you in a better position for a loan approval. But keep in mind that late or missed payments could hurt your cosigner’s credit, too. You also need to come to an agreement with the cosigner about how to handle ownership of the property and figure out the tax implications for each of you.
  12. Have an emergency fund. While paying down debt and saving for your down payment are important, perhaps most essential to your financial wellbeing is to have savings for an emergency. Having a healthy savings account can also help you demonstrate your financial strength to a lender, along with preparing you for the unexpected costs of homeownership.

The bottom line

An excellent credit score can help you qualify for the lowest mortgage rates, but bad credit won’t necessarily stop you from becoming a homeowner. Working to improve your financial strength by paying down debt and saving can also help you slowly improve your credit score. In the meantime, meeting with a lender, housing counselor and/or credit counselor can get you free or inexpensive professional advice about loan programs and homeownership assistance that may pave your way to becoming a homeowner.


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