If the time is now right for you to buy a house, whether due to a growing family or because you want your monthly payments to go into equity (and you want the mortgage interest deduction on you taxes), you will want to have the best credit scores possible. This will allow you to secure a mortgage on more favorable terms, including a t a lower interest rate.
What can you do, however, if your credit scores are low? Will that place your dreams of homeownership out of reach? Let’s look at how the mortgage banking industry treats consumers who have low credit scores.
The first thing you will need to do is to find out what your credit score is, and here there is good news and bad news. The good news is that the three major credit bureaus are required to provide you, for free, with a copy of your credit report once per year. The bad news is that mortgage lenders rely primarily on your FICO score, and FICO is permitted to charge for a copy of its report, usually about $20. You can get a free approximation of your FICO score from CreditKarma, however.
Once you have your score, or an approximation, you can evaluate it as follows. Anything under 620 is poor, 620-699 is fair, 700-749 is good, and if you score above 750, your credit is excellent.
The advantage of conventional loans is that they either do not impose mortgage insurance payments, or they do so on terms that are more favorable than government-supported loans. These loans are generally not available to borrowers whose credit scores are below 680. Moreover, as your score gets lower, your required down payment goes up. And conventional loans usually require that only 36% or less of your gross income be used to pay of all revolving and installment debt bills, including not only the proposed mortgage but student loans and credit card debt.
The government likes homeowners, and it decided long ago to enter this market in a big way by supporting and securing mortgage loans. So if your credit score is under 650, The Federal Housing Authority (FHA) has a program that will insure your loan against default, so long as you can put a down payment of 3.5% of the home’s value on the table.
While the FHA will extend this insurance to borrowers all the way down to a credit score of 580, most lenders will not bite below a 620 score. Remember, the FHA doesn’t lend, it just guarantees in the event the borrower defaults. If the banks are not confident that home values are going up, they won’t issue a mortgage even with a guarantee because they don’t want to get a depreciating house back, they want to get those monthly payments. It’s therefore more likely that you will need to put down a down payment of around 10%.
FHA loans require both a sufficient credit score, and proof of income, which will be used to figure out your debt-to-income level. The FHA follows more relaxed guidelines than do conventional loan issuers for this ratio. You will only need to show that the debt payments come to no more than 41% to 43% of your income, in order to qualify for an FHA loan. Debt payments, however, include not only the mortgage, but also all other monthly debt payments.
In response to the hardships that have been inflicted by the lingering financial recession, the FHA has produced its “Back to Work” program, which allows people who have suffered a demonstrable financial set-back to qualify for a mortgage loan after a period of unemployment or under-employment which reduced their income. This program distinguishes between people who have mismanaged their credit and people who have gone through a period of bad luck, but who do not have a record of mismanaged credit. If you think you fit in that category, the FHA’s Back to Work program (really, it’s a back to making mortgage payments program) may be for you.
Another method for acquiring home ownership when you have bad credit is owner carryback, where you arrange to make payments directly to the seller, plus monthly deposits that go toward a later down payment. The seller will carry the mortgage for a certain period, possibly five years or so, and the buyer, using those monthly deposits, will then make a balloon payment as a down payment, or arrange for a regular mortgage. This process assumes that the buyer will be able to repair his or her credit prior to seeking the regular mortgage.
So there is hope for home ownership even if your credit is impaired, either through FHA loans or private arrangements with willing sellers. Of course, careful spending and saving habits are always important, but with a little creativity and discipline, you may not necessarily have to wait forever to own your own home.