Buying a home is an integral part of the “American dream,” but it’s increasingly out of reach for many hard-working adults.
The real estate market has been very competitive over the past year as the supply of housing has shrunk considerably. Now, many adults have given up owning a home and expect to rent for the rest of their lives. While most older generations will have their own home until retirement, less than half of the largest group in the workforce – Millennials – think they will have the same luxury.
Despite their pessimism, a competitive market doesn’t mean it’s impossible to own a home, even if you have bad credit.
But what is a bad credit rating?
Credit scores are generally based on the FICO scoring system, and different credit bureaus may rate scores differently. Here’s how Experian classifies them:
- Poor: 300-579
- Fair: 580-669
- Good: 670-739
- Very good: 740-799
- Exceptional: 800-850
About a third of consumers have a poor or fair credit score. If you fall into this category, don’t give up on home ownership. Some loans are specifically for Americans with low scores.
A traditional mortgage is usually a fixed rate loan, so the interest rate never changes. Although this is the type of loan people usually think of, it is only ideal for people with a credit score above 620.
In contrast, an adjustable rate mortgage (ARM) typically has a fixed interest rate for the first three to seven years, but then fluctuates with the market thereafter. ARMs are best suited for people with a credit score of 600 or higher. This difference between 600 and 620 may seem small, but it can help someone who needs it.
When market rates are lower, the interest on your loan will also be lower. The downside, however, is that if the rates are high, you’ll pay more too. You’re at the mercy of the economy — you could save money on the interest rate or lose it.
If you have a score as low as 500, you may qualify for a loan from the Federal Housing Administration (FHA). FHA loans will cover about 97% of your home’s value, so you’ll need to put down at least 3% down. and until you pay off 20% of the value of your home, you will have to pay for private mortgage insurance. This covers your lender in case you default on the loan.
Since this is a government-backed program, you will need to go to an FHA-approved lender.
Now that you know the different loan options, it’s time to take a look at the steps to get there.
Step-by-step guide to buying a home with poor credit
With so many loans and interest options, the best thing to do is talk to a professional who can review your situation and find the best path for you.
Step One: Get Your Free Credit Report
The last thing you want is to have your credit score misreported. Go to annualcreditreport.com — you can get a free copy of your credit report each year. Review all the information provided. Is your social security number correct? Are your addresses up to date? What debts and transactions cause you to lose points?
If anything seems incorrect, contact your lender. It can be something as simple as a paperwork error or as serious as identity theft. Work with your lender to obtain documentation proving the error and contact the credit reporting agency with the evidence. The Federal Trade Commission even offers a sample letter you can use to dispute any errors.
Step Two: Do What You Can to Increase Your Score
Unless you’re in a rush to buy a home right away, take the time to improve your credit score as much as possible. Five factors determine your score. From most to least critical are your payment history, your outstanding debts, the length of your credit history (how long you’ve had your cards), the types of credit you’ve used, and the amount of new credit.
You can sign up for a credit monitoring service to help you track all of this. An app called SmartCredit offers a paid service and is one of the most useful options. You can also use free tools, although they are not as in-depth. One example is credit karma. It can point out the credit factors that are hurting or helping you the most, but it won’t give you detailed advice on how to fix those issues.
Step Three: Talk to a Professional
The best person to talk to is a Housing Counselor licensed by the Department of Housing and Urban Development (HUD). The government trains these advisers, in particular the Ministry of Housing and Urban Planning. Their job is to help you find affordable, quality housing. They will get to know you and your situation, so they can find local options that suit your situation.
Step Four: Register for a Workshop for Homebuyers
If you can take a course locally, it should be free. You can also do it online at your own pace. However, there will likely be a charge for this. Upon completion of the course, you will receive a certificate which you can use when applying for funding. The HUD advisor should be able to help you with this.
Fifth step: search for Fha loans
As mentioned earlier, Federal Housing Administration (FHA) loans are the best option for someone with poor credit. The loan will not come directly from the FHA but through an approved private lender. Your local HUD office should be able to find the best option in your area. Make sure you have enough funds to cover the down payment and mortgage insurance costs.
Step Six: Try to get pre-approved
Like any other mortgage, you can get pre-approved for an FHA loan. Pre-approval can help you save time and narrow your search when looking for a home. Like a licensed advisor, this will help you understand what you can and can’t afford so you can look within your price range.
Getting a pre-approved mortgage also makes you a much more attractive buyer to whoever is selling the home. It’s a great boost, especially in a competitive market like the one we know today. Once approved, do not spend money on furniture or other expensive items. Banks will monitor your activity, so be sure to stick to your budget.
Keep three main goals in mind as you go through your house hunting journey: save for a down payment, track your credit, and work with a professional.
This allows you to find a mortgage option that suits you despite your low credit score.