If there’s one thing you need to secure a mortgage, it’s good credit. As a first-time homebuyer, you already pose a high risk to lenders because you don’t have a mortgage payment history. Lenders use this to determine how likely you are to default on your loan. Without that history, the next best thing is great credit.
Does that mean if you have bad credit that you won’t be able to get a home as a first-time homebuyer? Luckily, you still have options.
The FHA Loan
The FHA loan used to be called the ‘first-time homebuyer’s loan’ for good reason. It has flexible guidelines, which include low credit score and low down payment requirements. The FHA allows credit scores as low as 580, but in some circumstances, they allow lenders to accept scores as low as 500.
Here’s how it works.
If you have a credit score of at least 580, you can put down as little as 3.5% on the home. The down payment can be your own funds or gift funds. The FHA doesn’t require that any of the money come from your own sources if you have at least a 580 credit score.
If you have between a 500 and 580 credit score, you may still get FHA financing, but you’ll need a down payment of at least 10%. In addition, at least 3.5% of that amount must come from your own funds. In other words, you can’t accept gift funds for the full down payment.
Typically, FHA borrowers have at least the 580 credit score, and sometimes even higher, though. The FHA doesn’t fund the loans – it’s up to the lender to decide what credit score they require or what risks they will take. This does give you some flexibility to shop around and find a lender that will accept your circumstances.
If you can’t qualify for an FHA loan, your next best option is a subprime loan. These loans, you may have heard, used to allow stated income or no verification of your assets. Today that’s not the case. Every lender must provide proof beyond a reasonable doubt that you can afford the loan.
So how do subprime loans help if you have to verify your income? There’s one reason – the lender’s requirements. Because subprime loans aren’t sold on the secondary market, the lender gets to make the decision whether or not to lend to you. This may mean lower credit score requirements, especially for first-time homebuyers.
Again, you may have to shop around with different lenders to find one that will meet your requirements.
You Need Compensating Factors
If there’s one thing that can help you get qualified for a home loan even with a low credit score, it’s compensating factors. Here’s why.
A low credit score tells a lender that you are financially irresponsible. They will look over your credit history to figure out why you have a low score. Do you make your payments late? Do you default on your loans altogether? Did you file bankruptcy? Did you go through a foreclosure? These things let a lender know your financial tendencies.
But, if you’ve picked up the pieces since these incidents, but your credit score hasn’t quite improved yet, you can show your stable status with other things called compensating factors. They include:
A large down payment – The more money you have saved to put down on the home, the more invested you are in the property. This makes the lender less liable for default as you are likely to make your payments on time in order to avoid losing your investment.
A low debt ratio – A low credit score combined with a high debt ratio is bad news. If you have a low debt ratio, though, you show that you are financially responsible. You don’t overextend yourself financially and you pay your credit card bills off as you charge them.
Stable employment/income – The longer you are at the same job and the more your income steadily increases at this job, the lower risk you pose. Staying at the same job shows a lender consistency, which speaks volumes when you are trying to get a loan.
First-time homebuyers with bad credit do have their work cut out for them, but there are ways to get you a loan. We recommend starting with the FHA program as it has the most flexible guidelines with the most competitive rates. If that’s not an option for you, trying a subprime loan is your next option.