You have been looking for your dream home; you have enough money for the downpayment and are ready to buy. Now it comes to getting the mortgage. But, after a very welcoming bank clerk examines your application and checks your credit score, you are denied the mortgage. It turns out your credit score is not high enough. What are your next steps?
This problem with insufficient credit score may occur for the following groups of people:
Self-Employed People. Self-employed people often struggle to prove their income. Also, many banks want to see a stable income. As a self-employed person, you also may have a lower credit score. With the rent-to-own program, you can own a home, build sufficient down-payment, as well as prove stable income to the bank when the lease ends.
Bankrupt. Bankruptcy put a hole in your credit report. Once the bankruptcy is discharged, it takes 2 to 3 years to repair the credit score to a point when big banks will want to give you a mortgage at good interest rates.
New to the Country. Getting a mortgage can be tough as an immigrant due to a lack of credit history and, as a result, low credit score.
Divorced. Divorce can often negatively affect your credit score.
Recovering from past credit mistakes. Everyone deserves a second chance, and past credit mistakes (if you are serious about fixing them) should not prevent you from owning your home.
The Federal Housing Administration, or FHA, requires a credit score of at least 500 to buy a home with an FHA loan. A minimum of 580 is needed to make the minimum down payment of 3.5%. However, many lenders require a score of 620 to 640 to qualify.
A low credit score will cost you a higher interest rate
Unfortunately, you have to be prepared that a lower credit score will result in a higher interest score and a demand for a bigger downpayment. The below table is a fictitious example of how a lender may vary interest rates for the different levels of your credit score and downpayment. For example, if your credit score is above 680 and you are prepared to give a downpayment of 10 to 14.99%, the lender will offer you an interest rate of 5.2%. If your credit score is from 600 to 619, with the same level of downpayment, the lender will offer an interest rate of 7.1%. With lower credit scores, the lender will demand a higher downpayment and will not approve your application with too low of a downpayment (e.g., credit score from 580 to 599 and a 10% downpayment).
How can you buy a house with a bad credit score or no credit score?
Not all is lost if you were rejected by a major bank and are serious about owning your home today. There are a few paths for you to explore to obtain the financing for your desired home.
❑ Be patient and fix your credit score.
We have already discussed the factors that impact your credit score and some potential ways to fix it fast by correcting information on your credit file, adding to your mix of credit accounts, reducing the number of credit cards, or reducing the balances on credit cards. You can read about fixing your credit in more detail in our post here: How to improve credit score? How is credit score calculated?
❑ Make a larger down payment.
As seen in the example table above, some lenders will still provide you with a mortgage despite lower credit scores but will demand a higher downpayment. Also, as seen above, higher downpayment may result in a lower interest rate.
❑ Check for all types of bad credit home loans available in your area.
You can look for programs widely used by first-time and low credit buyers, such as FHA mortgages, VA financing (zero down), USDA mortgages (zero down), Fannie Mae HomeReady mortgages (3 percent down), and the Freddie Mac Home Possible loan (3 percent down).
❑ Look for subprime lenders.
The sub-prime mortgage market has been growing over the past few decades. It provides the ability for borrowers that are declined by prime lenders to obtain financing, either to purchase a home or refinance their existing mortgage. While the big banks may have strict rules for the minimum acceptable credit score, there are plenty of smaller lenders such as second-tier banks, credit unions, and trust companies that will accept applicants with lower credit scores and can help you buy a house with a bad credit score. However, do be prepared that they may ask for higher downpayment and/or charge higher interest rates. Make sure you do some shopping around to find the lenders with the best rates and terms, as this may save you thousands of dollars down the road.
❑ Look for private lenders.
If your score is lower than 600, you might have no choice but to find a private lender. There are plenty of private lenders that act pretty much like banks. Private lenders are classified as individuals or groups of individuals who provide mortgage financing. These individuals have money to invest and have decided that mortgage financing offers a profitable rate of return. They will lend you the money for a purchase of a home in a similar way to the bank. Later, similar to a mortgage, you will be making monthly payments that cover interest and a part of the loan. However, be prepared that with private lenders – instead of being able to put a 5% down payment on your home, with a mortgage rate of 3-4%, you’ll likely have to put a down payment of 10-20% or more, and your rate will be 10-15%, or possibly even more. Usually, with such a high interest rate, private lenders are only a good solution for short-term borrowing (usually 1 to 3 years) while you are rebuilding your credit score.
❑ Look for seller financing.
In this case, the seller acts as a private lender. Usually, this happens when the seller is actively involved in lending business or has a property that otherwise is hard to sell. In this case, the seller of the property both sells you the property and provides you with a loan. There is an actual transfer of money happening other than you paying an agreed downpayment. You pay the downpayment, take the ownership of the property and pay the seller the remaining loan over the agreed term. When forming such an agreement, you would want to agree that you can repay the full amount of the loan at any time. As soon as you fix your credit and obtain a regular primary mortgage from a bank, you will pay the seller the outstanding loan in full and continue repaying the mortgage to the bank.
❑ Apply for Rent-to-Own.
A rent-to-own is an alternative if you cannot get a mortgage today. With rent-to-own, you rent a home for a certain amount of time, with the option to buy it before the lease expires. A rent-to-own arrangement is one in which you pay rent every month to the owner/landlord, just like you would as a tenant. However, with a rent-to-own program, a portion of the rent you pay goes towards your down payment for the future purchase. This amount is called rent credits. A rent-to-own program gives you the opportunity to grow your down payment while living in the home as if it was your own.
According to the contract with the investment of a rent-to-own company (we will refer to both as Investor through the article), they must sell you the home you are renting at the end of the lease. In some cases, you can add an option to buy your home sooner than the lease-end. You can read about the rent-to-own program, how it works, its benefits, and risk in another article I wrote: What is Rent-to-Own? How does Rent-To-Own work?
❑ Find a co-signer.
Likely one of the best options to buy a house with a bad credit score as you would be able to obtain a normal mortgage with good rates. However, if you don't have relatives or really close friends that can be your guarantors, this option can be unattainable. The co-signer may come in 2 forms:
A co-signer is a person who is helping the applicants get approved for the mortgage by being added to the application in the same way as an applicant or co-borrower, and will also be registered on title. A co-signer may be required if the applicant does not have sufficient income to qualify for the mortgage. The co-signer’s income (and debts) will be included. A co-signer is as fully responsible for the mortgage as the applicant.
A guarantor is an individual who is not registered on the title but who is guaranteeing to the lender that if the applicant fails to meet his or her obligations under the loan the guarantor will meet those obligations. The guarantor’s income and debts are not included in the mortgage calculations unless he or she lives in the same home. A guarantor may be required if the co-applicant(s) have poor credit but enough income to qualify.
In summary, we discussed a few ways to buy a house with a bad credit score. If you have been rejected by a bank but are still serious about buying your property now, you should not give up as there are ways to start owning your home today. However, please be mindful that most of the above ways to obtain the needed financing are rather short-term. While you can start owning a home today, you should work on improving your credit score to avoid high-interest rates and save thousands of dollars down the road.