Written by: Guest | Best Company Editorial Team
Last Updated: July 6th, 2020
Guest Post by CreditRepair.com
It is very easy to make financial mistakes that damage your credit. Once your credit score drops, it can be challenging to obtain financing for a large purchase such as a home. If your past financial history has sunk your credit score, you may think that buying a home is out of your reach, but that is not necessarily true. It is possible to obtain a mortgage even when you have bad credit, but it will require persistence, planning, and patience on your part. Understanding what is required to obtain a mortgage with bad credit, as well as the advantages and disadvantages, may help you make a decision that's right for you.
Advantages of homeownership
Homeownership can benefit your financial situation in many ways. For example, some of the expenses related to owning a home, such as property taxes and mortgage interest, can be deducted from your annual income taxes. Additionally, if you are a first-time homebuyer, you may be able to receive a mortgage tax credit certificate that will reduce the amount you have to pay in taxes every year.
Though it can be a challenge to obtain a mortgage with bad credit, having a mortgage may help improve your credit score. Payment history, i.e., paying all your bills on time, is a factor that helps to determine your credit score, and making mortgage payments on time may reflect favorably on you in this regard.
Furthermore, as you make mortgage payments, you build equity in your home. When you first make a home purchase with the help of financing, your mortgage lender has a significant interest in your home, but as you pay off the mortgage, your interest in the property increases as your lender's decreases, and you own a larger portion of the home until the loan is paid off.
The portion of the home that you have paid off is referred to as your home equity. Equity is an asset that you can borrow against. If you owe a significant amount in credit card debt, you may be able to consolidate it with a home equity loan, decreasing your credit utilization ratio and potentially improving your credit score as a result.
Disadvantages of obtaining a mortgage with bad credit
When your credit is bad, lenders regard you as an investment risk. Understandably, this makes them reluctant to finance your mortgage. You may have to do a lot of searching to find a lender that is willing to extend a loan to you. Even then, the lender will likely make exacting demands of you that it wouldn't require from someone with a higher credit score:
- Homebuyer education — You may have to attend a homebuyer education course approved by your lender before it will let you take out a mortgage.
- Higher closing costs — Lenders prefer to have a financial "safety cushion" of sorts in place to protect them in the event that you default on mortgage payments. This may take the place of mortgage insurance that you pay in addition to conventional closings costs.
- Greater down payment — It is often recommended that homebuyers be prepared to pay 20 percent of the purchase cost as a down payment. This is a relatively arbitrary number that is not always required, but it may be close to the target of what you will be expected to pay down with a bad credit rating.
- Higher interest rates — Another way that lenders protect themselves when financing someone with bad credit is by charging higher interest rates than they would otherwise. Accepting a higher interest rate may allow you to obtain a mortgage that would be out of your reach otherwise, but it will increase the amount you will have to pay each month.
You will have to weigh the disadvantages of obtaining a mortgage with bad credit against the advantages of homeownership as they apply to your current situation to determine whether it is worthwhile for you to attempt to purchase a house now or wait until you improve your credit score.
Tips for obtaining a mortgage
The best way to avoid the disadvantages of bad credit when applying for a mortgage is to improve your credit. This is accomplished via two steps: Decrease your credit card debt and pay your bills on time.
These are relatively simple steps, but rebuilding your credit this way takes time. If you can't wait or don't want to wait until your credit improves, here are some other steps you can take that may help:
1. Know your credit score
Knowing your credit score can help you evaluate your options. You can get your separate credit scores from any or all of the three major credit-reporting agencies, or you can get your FICO credit score, which combines them all into one.
Everyone makes mistakes, including credit-reporting agencies. It could be that there are errors on your credit report that are lowering your score. Check your report for any errors and take steps to correct them before applying for a mortgage.
2. Understand what makes a good credit score
It's not enough to know what your credit score is; you need to understand how lenders will perceive it. Credit scores range from 300 to 850. Anything above 700 is considered good, and you may have difficulty obtaining credit if your score is 600 or lower.
3. Shop around
Credit scores between 600 and 700 are something of a gray area. Some lenders may consider you a credit risk and refuse to lend to you if your credit score is within this range, while others may be more willing. Be persistent in your search for a lender; just because one says no, it doesn't mean they will all reject you.
4. Consider an FHA loan
The Federal Housing Administration seeks to help people buy houses who ordinarily wouldn't be able to afford to. Therefore, they offer mortgages with less stringent requirements when it comes to credit score, down payments, etc.
However, you should know that there isn't a special, separate government lender providing FHA loans. You obtain them the same way you would get any mortgage — through a financial institution. Be aware that a mortgage lender can still refuse to extend you an FHA loan, even if you meet the FHA's minimum requirements.
5. Enlist the help of a cosigner
You may be able to obtain a mortgage that you wouldn't otherwise be qualified for if you have a friend or family member who's willing to cosign for you. A cosigner's good credit can minimize the lender's perception of you as a potential liability. However, it can be difficult to convince someone to act as a cosigner because if you fall behind on payments, he or she will be financially liable for your default. It would be best if you had a plan in place regarding what you will do if you fall behind on payments and discuss the terms with your cosigner.
Though limited, there are options available for the home buyer with bad credit. However, it may be more advantageous to repair your credit before trying to purchase a home. A reputable credit repair company may be able to help.