You can get a mortgage with bad credit. Just ask Scott and Sally Champion, 30-somethings in Dallas, who set a goal of becoming homeowners no later than five years after their marriage.
They met that goal … despite having a credit score of just 600.
The Champions dream seemed to have little or no chance because the numbers simply didn’t add up. Their credit score was a horrendous reminder of their sad financial situation. They had taken positive strides to escape a history of overextending themselves and struggling to make credit card payments.
Still, they had no money — zero — to make a down payment and almost didn’t apply.
Then, guess what? They were approved for a home loan.
No one was more dumbfounded than Scott and Sally. They had virtually none of the criteria that always seemed essential to qualify for a mortgage.
The old rules, they soon learned, have changed so if your credit history isn’t exactly stellar, don’t give up.
How to Get a Mortgage with Bad Credit
Scott and Sally received a Federal Home Administration (FHA) loan on a $200,000 mortgage with a 5.12% interest rate. That’s not the best rate in these days when sub-4% rates are common, but it’s not outrageous either given their poor credit score and uneven credit history.
Sally’s brother provided the funds for a 10% down payment, a gift that was allowed under FHA stipulations. Private mortgage insurance was required — 1.75% of the loan total up front, then an annual fee of 0.85% rolled into the monthly mortgage payment.
Here’s the kicker. The Champions were paying $1,400 in monthly rent for a nice two-bedroom apartment. Their mortgage payment, including taxes and insurance, was $1,511.98 — a virtual wash.
“We run into a lot of scenarios where people are saying, ‘Oh my gosh, I can’t believe I was actually able to purchase this property,’ ‘’ said Michael Belfor, a mortgage banker with American Pacific Mortgage Corporation in Novato, Calif. “I have clients calling me out of the blue, still thanking me. They feel like they have been blessed. And maybe they have.’’
Home purchases are also a blessing for the overall economy. Al Bowman, president of Mortgage Commentary Services in Tampa, Fla., said he believes the resurrection of the “subprime mortgage market’’ (for those with poor to bad credit) is driven by rising property values and Wall Street’s willingness to buy the loans.
“In a rising value environment, there is less risk of taking a loss if the borrower defaults,’’ Bowman sad. “This allows the lenders to make loans they would not (make) when property values are declining.
“But with any mortgage product, there must be liquidity in the secondary market for lenders to continue making new loans. That’s where Wall Street comes in. As long as there is a demand for the securities in the financial markets, lenders will continue to make these loans.’’
Renters with Bad Credit Can Save by Buying
Skyrocketing rent prices have pushed more people toward purchasing a home. Even with higher interest rates, it turns out to be a better deal to build equity at similar monthly prices.
According to the U.S. Census Bureau, the average rent in the first quarter of 2017 for a home or apartment was an all-time high $864. Median rent was around $500 in 2000 and it rose to $700 during the Great Recession, hitting the $800 monthly mark for the first time in 2015.
For renters looking to get out, there are two types of mortgages — conventional and government-assisted.
FHA loans were created by the Federal Housing Administration in 1934 to increase home ownership during the Great Depression. They have been utilized by more than 40 million families to purchase or refinance homes. The loans are insured, so lenders have greatly reduced risk. In 2017, FHA loans made up 20% of all new loan originations.
How Low of a Credit Score Can You Have to Get a Mortgage?
Here are some general parameters for how your credit score affects your ability to qualify for a mortgage:
Below 600 Credit Score
For FHA loans, a credit score as low as 580 can be accepted, with just 3.5% in equity. Scores dipping to 550 have been accepted, but a 10% equity position is required (either 10% down when purchasing a home or 10% equity when refinancing). Down payment assistance is non-existent and you will have a difficult time getting approved if your debt-to-income ratio exceeds 45%.
You might be required to show that a financial hardship was the reason you fell behind on your monthly bills, while displaying evidence that you have recovered.
Hopeful note: Nearly 20% of all homebuyers have credit scores below 600.
600-650 Credit Score
This range makes up 20% of all FHA loans. Conventional loans generally have a 620 minimum credit-score requirement. FHA loans allow debt-to-income ratios that exceed 54%, but a credit score of 640 is generally needed to secure the loan. You also could qualify for VA loans and U.S. Department of Agriculture loans. If you have been through a previous short sale, bankruptcy or foreclosure, there could be a waiting period (known as a “seasoning period’’) of two to three years before you can qualify for a mortgage. You might consider a debt consolidation program to help repair your credit score.
650-700 Credit Score
Nearly 40% of the FHA loans fall within this range. You still will be considered a bit of a risk, but you could be able to obtain the conventional loans from Fannie Mae or Freddie Mac. Those are the Congress-created entities that buy mortgages from lenders. By selling the mortgages, lenders use the raised cash for more lending. They can be held or packaged into mortgage-backed securities (MBS) that could be sold.
700-750 Credit Score
Fannie Mae and Freddie Mac loans are much more achievable.
750 and Above Credit Score
Approval should be a formality. The average credit score for Fannie Mae and Freddie Mac approval is 754.
How to Qualify with a Low Credit Score
If you have poor credit, here are tips to help qualify for a loan.
Larger Down Payment
Essentially, a down payment reduces risk for the lender. You have skin in the game. They have a buffer. An excellent figure is 20%, which allows you to avoid private mortgage insurance (PMI).
Even with a large down payment, it’s helpful to have ample cash reserves on hand. It will make lenders comfortable that you can absorb the unexpected, such as a failing hot-water heater or a hefty medical expense.
Be able to verify that you’ve paid your rent on time consistently for 12 to 24 months. FICO estimates that less than 1% of credit files contain rental entries, so it pays to investigate alternative credit reporting tools.
They include: Rent Reporters (one-time enrollment fee of $45.95, then $9.95 per month, reports to TransUnion credit bureau); Rental Kharma ($40 setup fee, then $9.95 per month, reports to TransUnion); RentTrack ($2.95 per month, sometimes offered through landlords, reports to all three credit bureaus); ClearNow (debits rent from your checking or saving account, reports to Experian); PayYourRent (variable fees, reports to TransUnion and Experian); ERentPayment ($3 transaction fee for processing electronic rent payments, reports to all three credit bureaus).
If you opt-in to any of these services, here are some follow-up questions: What are the total costs for a year of service? How is my personal data protected? Is there free access to credit scores? How soon will rent information appear on my credit report? How can I cancel the service?
Explain Your Circumstances
It’s helpful to write a letter that explains the borrower’s circumstance while injecting some personality. In today’s world, letter-writing has become a lost art. If your words leap off the page, it’s an advantage.
You should address and account for each negative item on your credit report, even if it seems dated or insignificant. Tell why this problem won’t happen again and what has changed in your life to prevent it.
If there’s a medical issue, get some documentation from the doctor or include the bills. If you were laid off, include a copy of the termination letter or evidence of unemployment benefits. If there was no medical insurance, include proof that you have it now.
Document, document, document.
Bad Credit Lenders
There are some choices for mortgage loans to consumers with bad credit. It helps to know your options.
Mortgage Brokers vs. Banks/Credit Unions
According to Inside Mortgage Finance, an industry publication, mortgage brokers account for just 9.7% of the origination market. It’s a product of the housing crash, which saw tighter regulations for the industry and banks shifting to more in-house sales operations.
Due to the SAFE Mortgage Licensing Act of 2008, brokers must pass state licensing exams, proving they know the rules of financing. Under federal regulations, brokers aren’t permitted to accept premiums from lenders in exchange for steering customers into higher-priced loans.
Mortgage brokers are middlemen who represent many lenders and various loan products. The broker tries to match the loan product that best meets your needs at the best possible price. Once the loan is approved, borrowers generally deal with the loan originator or their mortgage service provider.
Banks, mortgage banks and credit unions are considered direct lenders. Employees of that institution review your application and decide whether to issue the loan. Typically, banks sell loans on the secondary market a few months after closing.
Benefits of Working with a Mortgage Broker
Mortgage brokers work with many different lenders to find loans for clients, but don’t give loans directly. If you ask a broker what they can offer that a bank can’t, it’s almost certainly going to be summed up in one word — variety.
If a borrower has a low credit score and isn’t certain to obtain a loan, brokers with lots of contacts could find a deal.
Downside? Brokers sometimes attempt to increase their profit by writing hidden costs into your loan. You must be educated about the process and ask questions.
Benefits of a Bank or Credit Union
The best deals can usually be found through a direct lender, simply because there aren’t many add-on fees or middlemen who touch the loan and get paid for it.
Direct lenders are in the volume business, so they can cut costs. Employees usually don’t get a commission, just an hourly rate, so they aren’t looking to create extra charges. They lend out their own money, so cash is made through the servicing of a loan, not through charging origination fees.
If a borrower fits the bank’s criteria — job stability, long-time residence and good income — the loan is practically automatic and follows a rote procedure. Money is made by processing a cookie-cutter type of loan — without extra work or effort.
Downside? Direct lenders offer only their own programs and there’s no comparison shopping and may have higher credit score requirements.
Can I get a mortgage online? Can I be approved for a mortgage online?
The short answer is: Yes!
If you can get groceries, a restaurant meal, a new set of steak knives, a vacation package or holiday gifts online, why not a mortgage?
While searching online, you will see names such as SoFi, Prosper, Lending Tree, Wells Fargo and others that offer mortgage services. Once it was considered risky and questionable. Now it’s mainstream.
Bowman, president of Mortgage Commentary Services, was among the first people to originate a mortgage loan on the internet in 1994. He remembers lots of media coverage and fanfare. But for most people back then, an online mortgage origination wasn’t to be completely trusted.
Fast forward. Recently, Bowman helped his daughter and her future husband get financing for their first home.
“In searching for the best deal for them, I found that all of the most competitive companies were Internet originators,’’ Bowman said. “It’s obvious that those lenders make up a huge part of the industry now.’’
Bowman said he found it fascinating that the loan officer was in Nevada, the underwriter was in North Carolina and the closing department was in California.
“Yet their transaction ran as smooth as if everyone was under one roof,’’ Bowman said. “We uploaded documents via a secure portal. We signed most of the disclosures electronically and communicated via e-mail. Even the realtor’s contract was done electronically.
“In the beginning, the Internet borrower did it to save money. Now the Internet lenders are not only more competitive in many circumstances, they are also more convenient. Who wants to gather pages of documents to go down to a brick and mortar office during business hours when they can accomplish the same thing sitting at a computer at 2 a.m., noon or 11 p.m., if they prefer? They are certainly viable options and should be considered by anyone looking to finance or refinance a home.’’
There’s nothing wrong with some comparison shopping between brokers and banks. There might be some excellent online options available as well.
If you’re willing to do some legwork, it’s typical to establish a spreadsheet with three or four mortgage sources, keeping track of interest rates (which change constantly), lock-in fees and points. You also need to know about closing costs, additional fees and whether there is a prepayment penalty.
With brokers, you should ask how they are compensated (it’s usually a percentage of the loan amount, anywhere from 1% to 2.5%) and whether they are paid by the borrower or the lender. Brokers are required to disclose their fees upfront and they can’t earn more than the disclosed amount.
Look for brokers who ask a lot of questions, instead of simply quoting their rates.
Ask friends and family members for suggestions, especially if they recently obtained a loan.
You can check credentials. Mortgage bankers are regulated by either your state’s department of banking or division of real estate. Mortgage brokers, if not regulated by your state, can be checked through the National Association of Mortgage Brokers or the Better Business Bureau.
There are good options online with attractive deals, but make certain you are dealing with a reliable broker or lender.
Which Lender Type is Best for Bad Credit Borrowers?
Mortgage loans aren’t always a one-size-fits-all type of proposition. But here are some general profiles of a borrower, along with the preferred route to a loan.
- Excellent credit, easy access to financial documents, long-time employee of one company: Online lender or bank.
- Self-employed borrower who doesn’t want to share data about income or assets with mortgage provider: Mortgage broker.
- Repeat home shopper, rate-and-term refinance customer, financially savvy: Online lender.
- Adjustable-rate shopper, relationship customer with many accounts and one institution: Bank
- Convenience shopper who wants easiest loan to get, even if it’s more costly: Home builder or real-estate agency lender.
Mortgage Underwriting: Manual or Automatic?
Mortgage underwriting is the process a lender uses to determine whether a borrower is qualified for a loan. It usually follows the “three C’s’’ of underwriting — credit, capacity and collateral.
There are two paths — manual and automatic.
Under manual underwriting, you are assigned a person to review your application. They will review documents such as credit score, debt-to-income ratio, bank statements and pay stubs, then make a decision on your ability to repay. If the underwriter is satisfied, your loan application will be approved.
Under automatic underwriting, it’s a computer-generated decision based on logic and algorithms, thus eliminating human bias. With systems that retrieve relevant data, such as the borrower’s credit history, it gives a near-instantaneous loan approval or denial. Some factors, such as income and assets, must be verified. Occasionally, applications might be referred to manual underwriting, which can require up to 60 days.
Manual or automatic: which is the better choice?
If you have bad credit or a complicated financial situation, the best choice might be manual underwriting. A computerized approval program might quickly decline the application because it focuses on pure data. Manual underwriting is cumbersome and time-consuming, but probably the better option for borrowers who don’t fit a standard mold.
Here are some scenarios that might be quickly rejected by automatic underwriting (thus begging for a manual review):
- Debt-Free Lifestyle: Great credit scores are reflected by a history of borrowing and repaying loans. If you have no interest costs, your credit evaporates. It’s not bad credit. It’s no credit. That is better interpreted with a human touch because it’s possible to get a loan with no FICO score through manual underwriting. Having no credit is always better than having things like bankruptcy in your credit reports.
- New to Credit: If you’re just starting out and haven’t begun to build your credit, you’re better off with manual underwriting or perhaps waiting to buy a home. Once you get that home loan, your credit outlook should be fine.
- Recent Financial Problems: Manual underwriting provides more loan options after a bankruptcy or foreclosure.
- Low Debt-to-Income Ratios: It’s always a good idea to keep your spending lower than your income. Manual underwriting allows you to go higher, but be careful not to stretch too far and buy an expensive property that could make you “house poor’’ (spending a large portion of your total income on your home and its upkeep).
Know that the approval process probably will be frustrating and monotonous.
Someone will be taking a very close look at your finances. Why not give them all the help possible?
Take an inventory of your finances so you can discuss everything with your lender. You can augment the credit report by showing your payment behavior on large items (such as rent) and the day-to-day (such as utilities, memberships and insurance premiums).
It’s helpful to identify at least four on-time regular payments you’ve been making for at least the last year.
Government loan programs (FHA, VA, USDA) are less risky for lenders, but not all lenders do manual underwriting, so you might have to shop around. Don’t give up after the first negative response.
There are also “compensating factors’’ that will help your application.
- Having liquid assets that cover your mortgage payments for three to six months.
- Having your monthly payment not exceed your current housing expense by the lesser of 5% or $100.
- No discretionary debt.
- Additional income. Automatic underwriting doesn’t count overtime, seasonal earnings and other items that could add to your income. It can be reflected through manual underwriting as long as it’s documented and expected to continue.
Generally, the idea is to show that the loan won’t be a burden and you can afford to repay. Job stability and having financial reserves are key factors.
It can be a slow process when an actual person is responsible for determine whether you qualify for the loan. It’s important to provide documentation and make sure you keep a copy of everything you submit.
There are several advantages to automatic underwriting.
- From application to approval to closing, the process could take as little as two business days to a week.
- Closing costs are reduced.
- Borrowers who weren’t previously approved will be helped by a higher debt to ratio allowance.
- There’s no threat of personal prejudice.
- Loan products can be tailored to the borrower.
The downside? Home loan turnover has tripled. Because the credit score is so important, sometimes the ability of a borrower to repay is overrated and it leads to more defaults that harm the mortgage industry.
Subprime Mortgages: Pros and Cons
Subprime mortgages are loans granted to borrowers with low credit scores (usually below 600), who would otherwise not be approved. Because of the risk assumed by lenders, these mortgages come with high interest rates.
Volatile adjustable rate subprime mortgages — with initial low rates, then a jump to higher figures — were common in the run-up to the real estate meltdown of 2007
Economists blamed them for part of the downturn. There was a regimented era that followed. Many lenders refused to give a mortgage to anyone with a credit score less than 680. Now there’s fear of economic ramifications with the subprime revival.
Everyone’s situation is different, but subprime mortgages come with pros and cons.
Pro: People with low credit scores can own a home without years of trying to establish better credit. That type of activity could stimulate the economy.
Con: Closing costs and fees are higher than normal. Of course, the lender wants as much money up front as possible because there’s a higher risk of default from the borrower.
Pro: Subprime loans can actually help borrowers fix their credit scores. Borrowers can use it to pay off other debts and then work toward making timely payments on the mortgage.
Con: Borrowers might not need an average or better credit score, but they must show they have sufficient income to make the monthly mortgage payments.
Pro: It’s relatively easy approval. Borrowers can obtain money, even if they have defaulted on past loans or have outstanding debt.
Con: Higher interest rates, of course. Good credit could have the borrower qualifying for rates less than 4%. Under a subprime mortgage, it will be more than 8% to 10%. What does that mean? If you have a 30-year mortgage at 4% interest to borrow $100,000, the repayment on normal time will be $171,870. With 10% interest, the repayment balloons to $315,926.
Predatory Mortgage Loans
It’s important to follow your instincts and listen to your gut. If something doesn’t seem right — beware! — you might be dealing with a predatory mortgage loan company.
- Large Fees — The lender’s fee (known as “points’’ or “discount points’’) for making the loan is generally 2%-3% of the loan amount. It should include an appraisal and title insurance. If it’s more, it’s a bad deal for you.
- Inflated Interest Rates from Brokers — It’s a way for brokers to make more money. They boost the interest rate above the lender’s actual charge. You should ask if the broker will be paid a “yield-spread premium’’ (the financial reward lenders pay for inflated interest rates.)
- Steering and Targeting — Some lenders target senior citizens and minorities, presenting them with unnecessarily expensive loans. Telltale signs: Ads that say “bad credit doesn’t matter.’’ Lenders that contact you and try to rush you into a decision.
- Rates That Adjust Dramatically — Watch out for adjustable rate loans that rise significantly, especially if it isn’t possible for the interest rate to go lower. Fully understand the worst-case scenario and don’t think you can dig out from the problem with refinancing.
- Promises, Promises — It’s never good when a lender talks you into a bad deal by promising to refinance the loan later. Simply say no if the loan stretches you too far now or in the future.
- Repeated Refinancing — The so-called “flipping’’ will cause you to lose more money in points and fees. It adds up and you’ll end up owing even more on your house.
- Failing to Add It Up — Lenders should establish an escrow account for property taxes and insurance so you’ll have an accurate view of your monthly mortgage payment. Unscrupulous lenders can make the payments seem low by conveniently not mentioning them. You’ll realize you’re responsible for a higher payment — after the fact.
- Bad (Or No) References — Lenders should have online reviews, information on the Better Business Bureau database or some type of past client experiences.
- Buddy System — Beware of being steered to a specific lender by an agent or builder. They should be seeking a good lender and smooth process. Sometimes, the recommendations are driven by illegal kickbacks, easier underwriting guidelines or larger commission checks.
- Too Much Pressure — Are you being told to falsify statements in the name of “helping’’ your mortgage application? Are you being advised to borrow more than necessary, which would mean a larger commission? Are you being asked to sign a blank document? Are the costs, fees and commissions different than initially agreed upon? These should be obvious red flags. You shouldn’t be rushed or pressured into any decision when you aren’t comfortable. There must be a level of trust.
The Future of Bad Credit Home Loans
The FHA has relaxed its loan stipulations to levels that haven’t been seen since pre-2007. At the same time, lenders generally impose tougher guidelines for FHA loans than the FHA itself.
Why? The FHA penalizes lenders for approving too many bad FHA loans — even if the loan fits within FHA guidelines — so there’s a self-policing layer in play.
“It’s definitely not the market I remember from back in the day,’’ Belfor said. “Ten years ago, if you had a FICO score and a pulse, you got a loan. And in some circumstances, you didn’t even need a pulse. There were actually cases of people using credit scores and Social Security numbers from the deceased.
“Now we’re looking at a real individual, their ability to repay, their income and, of course, their credit score. But we’re looking in the context of, ‘What does this really look like and what caused this and what is their ability to repay?’ These aren’t bogus loans. They are done with qualified underwriting guidelines. I just think it’s different than it was before.’’
From 2004 to 2006 — just prior to the Great Recession — subprime mortgage originations increased from the historical figure of 8% or lower annually to 20%. There were lower lending standards and a proliferation of higher-risk mortgage products.
When U.S. home prices declined steeply after the housing bubble peaked in mid-2006, borrowers had more difficulty refinancing their loans.
By the end of 2007, the ratio of household debt to disposable personal income had risen to 127% (it was 77% in 1990).
The subprime mortgage market was slashed in the recession’s aftermath, but it has made a comeback, although regulations and safeguards are in place. Housing prices have risen 30% over the past four years, mirroring the 2006 level.
Marina Walsh, the Mortgage Bankers Association Vice President of Industry Analysis, said things are different. In early 2017, the overall mortgage delinquency rate was at its lowest level since the second quarter of 2000. Additionally, the foreclosure rate was at its lowest level since the first quarter of 2007.
But within those statistics was an increase in the “subprime market’’ — the borrowers with poor or bad credit. Subprime borrowers entered foreclosure at a rate of 2.43%, up from 2% in the previous quarter, a figure above the norm in a healthy economy. MBA chief economist Doug Duncan said the figures were skewed by rising foreclosures in Arizona, California, Florida and Nevada.
There’s a debate over what this means in the long term. Karen Weaver, global head of securitization research at Deutsche Bank Securities, called it “the tip of the iceberg’’ and predicted a rise in subprime mortgage defaults over the next two years. Michael Youngblood of FBR Investment Management sees recovery and stabilization, provided unemployment and interest rates don’t increase.
“Deja vu? To anyone who cares to see it, it should be obvious,’’ Bowman said. “The current subprime mortgage products are more controlled and make up much less of a market share than they did before the meltdown, but the formula is still the same.
“The percentage of subprime loans now are much smaller than years ago. I don’t believe there is much concern at this point. However, that doesn’t mean there shouldn’t be (concern). … That could very well change in the future if the products become more prominent, especially if property values stagnate or broader economic conditions weaken.’