If you’re looking to get out of renting and plant roots for a while, buying a home can be a great move for your life and finances. However, if you’re still working on fixing your credit, you may wonder if buying a house with bad credit is even possible! In this article, we’ll be looking at that question. Plus, we'll go over the steps you can take when buying a home with bad credit to give yourself the best chance at success.
Can you buy a house with bad credit?
Buying a home with bad credit may not be easy, but it can be possible for you. You’ll just have to invest a little more time in planning and preparation before you start seriously house hunting. That said, it is a very individual process. Buying a house with bad credit might not be in the cards for everyone, as it depends on a variety of factors, including:
- How bad your credit is
- Your source of income/how much/how steady it is
- What other debts you have
- Whether lenders in your area are willing to work with you
In the steps below, we’ll get deeper into some of these factors and how you can use some of your strengths to overcome your weaknesses.
Steps for buying a home with bad credit
When you’re considering buying a house with bad credit, going through these steps will help you find out where you stand and what to do!
1. Pull your credit report
The first step, of course, is to find out where you’re starting from and what credit score you’re working with! You can get the most official report from AnnualCreditReport.com, but you’re typically limited to one a year for free. This gets you a report from all three of the main credit bureaus (Equifax, Experian, and TransUnion). They all use slightly different metrics to measure your score, so you should expect a different number from each bureau, though they’ll likely be in the same general range.
There are also free services like CreditKarma to check more frequently and monitor how your score is changing. CreditKarma uses your Equifax and TransUnion scores. To help you determine your credit health, the different credit score ranges are divided into these categories:
- Exceptional: 800-850
- Very good: 740-799
- Good: 670-739
- Fair: 580-669
- Poor: Under 580
A score in one of the top two ranges will earn you the best interest rates, while you’ll struggle more for approvals in the bottom two. The “good” range is fairly average, so you might not qualify for every offer once you hit 670, but you’ll have more options.
2. Prepare to pay higher mortgage interest
A low credit score signals higher risk to lenders. To compensate for that risk, any loan offers they make will typically come with a higher interest rate (e.g. a 5% annual interest rate instead of 3% with a good score). These single-digit differences may sound small, but they add up when you consider that a mortgage lasts for 15-30 years. This article has examples of how your credit score can affect your mortgage rate, and how much extra you might pay over time.
Fortunately, even if you start out with a high-interest rate on your mortgage, it doesn’t necessarily mean you’re locked into that rate for life. You can explore refinancing your mortgage for a lower rate down the road when your credit is better.
3. Pay off your other debt
Something that can be even more important to mortgage lenders than your credit score is your “debt-to-income,” or DTI ratio. The name of this measure is very descriptive. It simply compares your total monthly debt payments to your total monthly income. This allows lenders to get a sense of how much other debt you have and what percentage of your income you can dedicate to the rest of your monthly expenses.
To calculate your own, add up your monthly debt payments (things like credit card payments, car loans, and student loans, plus the future mortgage payment you're planning). Then divide it by your typical monthly income. Lenders prefer DTI ratios below 36%.
If you currently have a big monthly burden of other debts, plan to work on them before you pursue buying a home. Getting your other debts paid off looks good to lenders, will help improve your credit score, and will lower your DTI number. Read 6 steps to paying off debt here!
4. Determine your budget
Before you start shopping around and get your heart set on a dream home that's out of a sensible price range, sit down and determine what you can comfortably afford. You don’t want to buy more house than you need and be “house poor”. This is essentially spending a high percentage of your income on your mortgage/home expenses and not having much left to save/invest/use for other expenses.
Since you’ll also probably be paying higher interest when buying a house with bad credit, it’s even more reason to buy below your means. A good rule of thumb is to spend no more than 28% of your annual gross income on a mortgage. E.g. if you make $50,000/year, you'll want to look for a house and mortgage that costs you a max of $14,000 per year, or approximately $1150/month.
While you don't have to include other home-related expenses in this 28%, you should still consider them. If you're buying a fixer-upper because it's cheap, research how much the necessary improvements will cost. This way you're not taken by surprise.
5. Save up a down payment
When you're buying a home with bad credit, saving up a sizable down payment can make it easier to qualify with various lenders. Putting down a chunk of the purchase price means you can pursue a smaller loan. Plus, every dollar you can save up for a down payment is a dollar that won’t be accruing interest on your mortgage. Making a down payment of 20% of the home’s price is a good idea for two reasons:
Loan-to-Value (LTV) ratio
This number compares the amount of your loan to the value of the home. If you're buying a $150,000 home and put down 20% (so, $30,000), your mortgage loan amount will be $120,000. Compare the loan amount to the home's value—$120,000/$150,000—and you get an LTV ratio of 80%. If you only put down 10% ($15,000) and get a $135,000 loan, the LTV ratio would be 90%. Lenders don't like to see high LTV ratios. This is because you're more likely to default on your loan if you don't have much equity in the home. Thus, they may charge you higher interest rates if your LTV is above 80%.
PMI (Private Mortgage Insurance)
If your LTV is above 80%, you'll also likely be required to pay PMI (private mortgage insurance). This insurance protects the lender in the event that a borrower defaults on their loan. Since you're considered higher-risk with a smaller down payment, you basically pay PMI in trade for them being willing to insure you.
Now, this doesn't mean you absolutely have to save a 20% down payment. If you're paying a lot in rent each month, it could still be cheaper for you to buy a home even with higher interest and PMI. As long as you can get approved, of course. The moral of the story is just that if you can pay 20% or more, it's a smart thing to do. It might take some time, but don't be disheartened. Follow these tips for saving a down payment and be patient; you'll get there!
Once your bank account hits your goal down-payment number, keep saving so you have a buffer. You should still have an emergency fund. This way you're prepared for unexpected expenses and life circumstances.
6. Leverage an FHA loan
Federal Housing Administration (FHA) loans are designed to put homeownership within reach for people who may struggle to get a conventional loan. They're particularly ideal for first-time home buyers, and typically require lower down payments than a private lender may. You'll need a credit score of at least 580 to qualify for an FHA loan with a 3.5% minimum down payment. If your credit score is between 500-579, you'll need a 10% down payment to get an FHA loan.
This all sounds great—but there are also a few downsides to getting an FHA loan. We talked about PMI above, and while it takes a different form with a federal loan, it's a similar idea. You'll actually pay for two types of mortgage insurance premiums (MIP):
- Upfront MIP: a one-time payment equaling 1.75% of your base loan amount. This can be paid upfront during closing or added on top of your loan.
- Annual MIP: recurring payments ranging from 0.45% to 1.05% of the base loan amount per year. The annual MIP is divided into 12 monthly payments each year, and you'll pay it for 11 years or the life of the loan. As your loan balance goes down, your annual MIP also decreases since it's charged as a percent.
As an example, let's revisit our $150,000 house. We'll say you put down $15,000, so your FHA loan amount is $135,000. Your upfront MIP is about $2360, and your first-year annual MIP could be anywhere from $600 to $1350. The more expensive the house and the lower your down payment, the higher both types of MIP will be.
Beyond the extra insurance costs, there are some other requirements for FHA loans. You'll need to have a steady employment (or self-employment) history for 2 years, work with an FHA-approved lender, and buy a house priced underneath a certain limit based on the cost of living in your area.
7. See if you qualify for a VA or USDA loan
If you're a veteran or you're a lower-income homebuyer in a USDA-eligible rural area, you'll have two other types of credit-flexible loans open to you.
- VA housing loans: Available to service members, veterans, and surviving spouses. Benefits include competitive interest rates, government backing, and low or no down payment requirements. Credit score requirements vary by lender. However, they are required to consider the entire loan profile instead of denying based on credit alone.
- USDA loan program: The United States Department of Agriculture offers mortgage assistance for those with low to moderate income in eligible rural areas. There's no PMI, down payment, or credit score requirements—lenders look at other parts of your financial history.
8. Improve your credit score
As mentioned, your credit score is a key determinant when it comes to the interest rate you get. Over the life of a mortgage, the interest you pay can easily amount to tens of thousands of dollars. And so, it's a good idea to prioritize improving your credit as best as you can before you commit to buying a home. If you envision homeownership in your future, start taking steps to improve your credit as early as you can. Be sure to give the process time so you can see improvements. This way you'll be on your way to the best interest rate possible based on your improved credit score.
Buying a house with bad credit is totally possible if you leverage these strategic steps. Even if you’re not able to buy a house right away, make it a goal to work toward and you'll get there. Take this free Clever Girl course for tips on building good credit. It's all about getting yourself on the right path to achieve your homeownership dreams!