As much as we may hate it, numbers can determine much of what we’re able to do in life. Just like you need a high GPA to get into the college of your dreams, so too do you need a high credit score to secure a loan on that dream home. But unfortunately, numbers don’t always reflect reality: Similar to how your boyfriend distracted you in chemistry and caused your GPA to plummet, chance financial mistakes can affect your credit score, and be hard to recover from.
“Today, bad credit isn’t just based on a number, but timing of recent derogatory activity like rolling late charges or a recent short sale or foreclosure,” says Joshua Vales, a mortgage loan originator with Mountain West Financial. Bad credit extends beyond the three-digit score we tend to use as our financial report card. But hope is not lost if you’re wondering how to get a loan with bad credit. Here are a few ways you can position yourself and your finances to improve your chances of landing a loan.
1. Save a larger down payment
For those with a credit score below 580, a larger down payment is a necessity — not an option. However, potential buyers with scores in a slightly higher range could use more money upfront to compensate for a low score. This would likely mean a down payment of 20% of the home value or higher.
A large down payment signals to the lender your ability to shoulder the loan despite your credit history, increasing your equity in the home upfront and immediately lowering your loan-to-value ratio. The idea is, the more you have invested in the home, the less likely you are to default — and the less risk you pose to the lender (even if your credit score is less than stellar).
2. Go with an FHA loan
When presented with borrowers carrying low credit scores, Vales points them in the direction of FHA loans — those backed by the Federal Housing Administration. The guidelines for these loans tend to be much more lenient than those owned by Fannie Mae and Freddie Mac, which provide financial products and services to make homeownership more affordable to low- and moderate-income borrowers.
According to the Department of Housing and Urban Development, the organization that oversees FHA loans, borrowers can be approved for an FHA loan with a score as low as 580, as long as they are able to put down at least 3.5%. Conventional loans, on the other hand, require scores closer to 620 or 640. Beware, however: FHA loans often come with higher fees attached.
3. Know what to emphasize to a lender
While many lenders use automated systems to automatically determine whether you are a good loan candidate, that doesn’t mean you’re out of the game should an initial run-through deem you ineligible. Lenders do have the ability to go the manual underwriting route, setting a low score aside if you can demonstrate financial stability in other ways — for instance, showing on-time rent payments for a year or more, or cash reserves of at least six months. A high income and low debt payments could also help portray you as a less risky loan candidate. In addition, be prepared to explain why your score is so low to begin with. While having a large amount of consumer debt in default can signal irresponsible spending and use of credit, medical and student loan debt can tell a different story entirely.
4. Try a private mortgage
Large financial institutions might be the first place you think of to get a loan, but there are less conventional means to get a loan with bad credit — like a private mortgage. Private mortgages can come from any party with the cash on hand to pay for your home purchase in full, upfront — e.g., a family member, friend, or private lender. You then pay for the home based on the terms set forth by both parties. While there are plenty of downsides to this type of transaction (potentially high fees and a high probability of relationship turmoil), it essentially makes your poor credit a moot point.
The bottom line? Poor credit doesn’t mean homeownership is out of reach
“We never just tell a client who has a goal of homeownership ‘no.’ We may say ‘not yet,’ but that is always followed up with a detailed plan on how to fix [their] credit, save money, and gear up for homeownership,” says Vales. So while that one three-digit number might change the path to your goal of homeownership, don’t worry: You’ll get there eventually!
What advice would you give to someone with less-than-stellar credit who wants to buy a home? Share your tips and experiences in the comments!