Qualifying for a home loan generally means you need good credit. At the very least, you need ‘decent credit.’ So what happens if you have poor credit? The good news is that you aren’t out of luck. The bad news is that you will have a little extra work to do. You can’t go to your local bank and get a conventional loan. Instead, you’ll need some alternative home financing options.
Don’t Forget FHA Loans
It doesn’t hurt to try to get an FHA approval. FHA loans allow credit scores as low as 580. In fact, you can go even as low as a 500 credit score if you have a 10% down payment. That’s 180 points lower than the average conventional loan requires.
Try applying with several FHA lenders to see if anyone will approve your loan. If you have other ‘compensating factors,’ such as a low debt ratio or a lot of assets, your chances of FHA approval are even higher. It’s up to each lender what type of risk they take, though. Just because the FHA allows credit scores as low as 500 doesn’t mean FHA lenders have to give you a loan. They still have the final say and they can add their own requirements onto what the FHA requires.
Subprime Lenders are Popular Too
If FHA loans don’t work out for you, don’t discount the benefit of a subprime lender. Yes, they were named ‘the reason for the housing crisis,’ but that’s in the past. Today, they are much more careful and offer many lucrative financing options.
The benefit of the subprime lender is they don’t have any rules they must abide by from anyone but themselves. They can decide on a case-by-case basis what type of risk they want to take. If you have poor credit, but there is something else outstanding about your loan file, they may give you a loan. Again, it comes down to your compensating factors. What do you have that makes up for your low credit score?
We recommend a low debt ratio for starters. Work on paying your debts down so that your debt ratio is as low as possible. This way when you apply for a mortgage, your housing ratio will be the major talking point. The lender won’t have to worry much about your miscellaneous debts that could make it difficult for you to make your housing payments.
Check With the Owner for Financing Options
Many sellers offer their own financing options to help them sell their home. If they own their home outright, they may be willing to help you become a homeowner by setting up seller financing for you. In other words, you secure the loan from the seller, not the bank.
If the seller finances your home purchase, they hold the note for the property. You then pay the seller principal and interest payments as agreed. You’ll have to work out the terms of the agreement before closing on the loan, just as you would with a bank. Of course, you’ll want to make sure you understand all terms of the agreement so you know what you are getting yourself into.
In many cases, seller financing is temporary. Buyers use this option to help them get ahead. Maybe they have poor credit and can’t find financing elsewhere. This can give them a chance to own a home, but also work on their credit at the same time. It’s also good for buyers that have a high debt ratio or a recent bankruptcy that prevents them from getting traditional bank financing.
Once you work your issues out, you can usually refinance the seller-financed loan, getting the funds from your bank and paying the seller off. He walks away with a little extra money in his pocket from the interest you paid him and you have the benefit of owning a home much longer than you would have been able to without the seller’s help.
Lower Your Debts
If you have poor credit, the best thing you can do is work to increase it. Figure out why you have the low credit score first. Is it due to late payments? If so, do what you can to get current on your payments. Then work on paying all of your bills on time all of the time. If it’s not late payments, but rather that you have too much debt, you may have to work on paying your debts off a little bit at a time.
Your debt ratio is the total of your minimum monthly payments divided by your gross monthly income. Let’s say you have $1,000 in total minimum monthly debts and $3,000 gross monthly income. Your debt ratio would be 33%. The lower your debt ratio, the higher your chances of approval, but each program has different requirements. For example, FHA loans require a 31/43 debt ratio. This means a 31% housing ratio (mortgage payments) and 43% maximum total debt ratio (all of your monthly debts). Conventional loans, on the other hand, require a 28/36 debt ratio.
If you have to turn to alternative financing options because you have poor credit, it’s not the end of the world. The best thing to do is shop around and find the best terms available. Each lender has their own requirements and charges different fees. Finding the loan that works best for you will help you save the most money on interest and fees in the long run.