Nine Steps for Buying a Home with Bad Credit
Written by
Andrew Flueckiger in an insurance writer for TrustedChoice.com. He's a licensed insurance agent who has earned his CIC designation and has written extensive insurance articles for many publications.
Reviewed by
Grant is the founder of Stewardship (in Gilbert, AZ) and was named a top entrepreneur before he reached the age of thirty-five.
If your credit score is poor, or if you don’t have credit, you may feel that buying a home is impossible for you. There are many reasons why your credit history may be poor, including trouble paying your bills due to past unemployment. Ideally, you’ll want to rebuild your credit and be able to provide a down payment before purchasing a home. But if buying a home now is important to you, follow these tips to maximize your chances of securing a home loan.
Step #1: Review Your Credit Report
The first step before you apply for a home loan is to know what’s in your credit report and find out what your credit score is. There are three nationwide credit reporting agencies that look at your information, such as your address, how you pay your bills and if it’s on time, whether you’ve been sued, and if you’ve filed for bankruptcy.
Review your credit reports carefully. If you find errors, such as reports of owed debts that have been paid or someone else’s credit information, you’ll need to file a dispute in writing with the reporting agency to have the information corrected. When you're reviewing your report, look for these items:
- The total amount going out vs. the total amount coming in: Your report is a summary to your creditors and any lenders of how much cash flow you have coming in vs. how much you're spending each month. Getting a good grasp on your budget is essential to making significate changes.
- Debt to income ratio (DTI): This will tell your lenders how much debt you have compared to your gross annual income. If your DTI is higher than 41%, most lenders will start flagging the account as too risky for their portfolio.
Step #2: Find a Credit Counseling Service
If you're struggling to pay off your debts or don’t know how to begin to raise your credit score, find a reputable credit counseling company. These agencies can help you arrange easier payment schedules as well as teach you methods to better budget your income. Though it may take two to four years to raise your credit score, this will help you to secure a traditional mortgage at a much more reasonable rate.
Taking this proactive step may also help lenders to view you more favorably and make it more likely that they will approve your application for a home loan. The Better Business Bureau recommends that you work with a credit counseling service that is fully licensed and certified.
Step #3: Make Peace with High-Interest Credit Rates
If you don't want to wait until your credit has improved, you'll likely pay significantly higher interest rates than a consumer with good credit. Those with poor credit may pay rates that are double those of consumers with good credit. This means that your monthly payments will be higher, so you may need to choose a home that is less expensive than you might want.
A higher interest rate means that you will pay a larger amount of money in interest over the life of the loan. For example, if you borrow $120,000 on a 30-year mortgage at a rate of 4.5%, you will pay $98,888 in interest over the course of the loan. However, if you take the same loan at an interest rate of 6%, you will pay $139,005. This is approximately $40,000 more paid in interest on the same amount of principle.
Step #4: Avoid Adjustable Credit Rate Interest Mortgages
An adjustable-rate mortgage (ARM) is often quoted with a low interest rate for a period of one to five years. After that period, your mortgage rate will fluctuate based on the going rate at the time.
Unless you are certain that you will be selling your home and moving on within a few years, an adjustable-rate mortgage will likely cost you more over time because your interest rate is likely to increase substantially. A fixed-rate mortgage is almost always the better choice when considering the amount of interest paid over the life of your loan.
Step #5: Avoid Predatory Credit Lenders
Predatory lenders may not be quite as common as they used to be, but they do still exist. They take advantage of those with poor credit who want to purchase a home.
Some indicators of predatory lending include putting extra pressure on you to take out a loan, setting up balloon payments, penalties for early pay off of the loan, unauthorized refinancing of your loan, and the request to sign documents that have not been filled out. Always ensure that the mortgage company or lender you choose is legitimate.
In general, there are four types of lenders that you can get a home loan from.
| Mortgage lenders: |
| 1. Banks: Banks are very common home loan options but are sometimes the least competitive when it comes to loan products. Part of this is because many people use banks simply for the convenience factors. |
| 2. Retail lenders: These are companies that sell loan products, but usually at a more favorable rate than banks. |
| 3. Correspondent lenders: Some local companies or brands offer mortgage loans in their own name through a correspondent lender. They typically charge a higher interest rate to consumers. |
| 4. Local independent mortgage brokers: These lenders oftentimes have the most competitive loan products because they work similarly to independent insurance agents, in the sense that they have options. Having options results in a variety of rates and term lengths to suit anybody's budget. |
Step #6: Save Money for a Large Down Payment
Having a large down payment will make it easier to be approved for a mortgage. It can also help you to get a better interest rate even with poor credit. If you can provide a down payment that is at least 20% of the total purchase price, you’ll be able to avoid having your lender add private mortgage insurance (PMI) to your loan payments.
Home ownership comes with many unanticipated costs, such as large appliance repairs or replacing your roof. Being able to set aside even a little money each month towards a down payment will help you save for these costs in the future. But don’t overextend yourself when you purchase your home. Be sure to factor in these types of unanticipated costs before you buy a home.
Step #7: Look into FHA Credit Loans
If you cannot afford to make a down payment now and you have poor credit, a Federal Housing Administration (FHA) loan may be a good option. These loans are backed by the FHA so that the lender can offer better deals for low-income, high-risk buyers.
The benefits to an FHA loan include low down payments, low closing costs, and easy credit qualifying. For those buying their first home, the down payment can be as little as 3.5%. For seniors, the FHA reverse mortgage allows some of the home’s equity to be turned into cash. If you qualify for an FHA loan, you will need to pay extra toward mortgage insurance. However, these loans enable home ownership that may have otherwise been unattainable.
Step # 8: Consider Rent-to-Own House Options
In a rent-to-own contract, you rent the home from your prospective seller. In addition to the monthly rent, you pay an additional amount for a specified length of time. After this time, the additional money paid goes toward the down payment.
For example, you may pay an additional $200 a month for a period of 5 years. This gives you plenty of time to rebuild your credit and have a down payment saved up, so that after the agreed period is over, you can apply for a traditional mortgage with a good rate. However, if you decide not to purchase the home, the owner may be able to keep the money that was intended for your down payment.
Step #9: Look for Houses Sold Through Seller-Financing
There are some investors who buy houses that are up for auction, typically through a foreclosure, and then sell the houses for a profit. Their business depends on being able to sell these houses quickly, and because of that, some of them provide financing options.
These investors are willing to sell low-cost homes to people with poor credit or no credit, sometimes at low or no interest. The houses are often in need of repairs, so factor in the cost of fixing up the house before you purchase. In these cases, if you default, the seller can rescind the deal and keep the money.
After you purchase your home, you’ll need to purchase and show proof of homeowners insurance before you can close on your loan. Contact a local independent insurance agent in the TrustedChoice.com network for help finding the best insurance coverage at the most competitive prices.