There might not be another material thing as important as the home you live in. But if you have a low credit score, it can seem like three little numbers run your life. Your credit score can dictate where you can buy a home if you’re approved for a loan, and what a mortgage costs you in the long run.
While it can seem like your options are limited, bad credit home loans are available. And depending on your situation, the terms may be better than choosing a conventional loan.
What are bad credit home loans?
Bad credit home loans are loans insured through the Federal Housing Administration. These loans are available for people with credit scores below 620. Most conventional loans require a minimum credit score of 620, but FHA bad credit home loans are available to people with scores as low as 500. FHA loans are popular with first time home buyers.
Bad credit home loans through the FHA are only available up to a certain point. They call this a loan ceiling. Loan ceilings are calculated by county. Ceilings of FHA bad credit home loans are 115% of the median home price in the area. For a one-unit property, the lowest an FHA loan ceiling can be is $314,827, even if the median price is significantly lower. If you live in a high-cost metropolitan area, the highest loan ceiling is $726,525, even if the median is significantly higher. These numbers are current for bad credit home loans in 2019.
FHA mortgages require mortgage insurance
You’d think bad credit home loans would have astronomically high-interest rates. If you’ve ever tried shopping for credit cards with a low score, you’ll see that the only offers you get have interest rates well above 25%. But for FHA mortgages, this isn’t the case.
The main reason bad credit home loans can still come with a decent interest rate is because of mortgage insurance. All bad credit home loans given through the FHA require mortgage insurance unless the borrower has put at least 20% down.
The premiums go into an insurance pool that’s managed by the FHA. As with many mortgages, bad credit home loans carry the risk of foreclosure. If an FHA home enters foreclosure, that money will reimburse the original lender. The FHA doesn’t issue loans. FHA insures borrowers who get loans through mortgage lenders. In this system, lenders are confident they’ll be repaid whether it’s through you or through the insurance pool. Because of this, they can offer reasonable interest rates on bad credit home loans.
MIP vs PMI
There are two terms to know of when thinking about bad credit home loans: MIP and PMI. The first one stands for Mortgage Insurance Premium. This is the mortgage insurance required by FHA loans. You must pay a MIP if you put less than 20% down on your home.
The MIP is both an upfront cost on closing and monthly payments. The upfront cost for bad credit home loans is usually the same for all borrowers: 1.75% of the loan amount. For example, if you financed a $200,000 home, you’d pay $3500 upon closing. The way they calculate your monthly payments varies depending on your down payment.
If you pay at least a 10% down payment, you’re required to pay MIP for 11 years of your loan. But if you pay less than 10% down, you must pay MIP for the entire life of the loan. For bad credit home loans, the amount of the premium can be between .8% and 1.5% of the value of the loan, paid annually. Most people take out a loan under $625,500 with a 3.5% down payment. In this scenario, they pay .85% MIP annually for the life of the loan. That can add $100 to $200 per month to the mortgage payment.
The other term, PMI, stands for Private Mortgage Insurance. This is mortgage insurance that applies to conventional loans (not bad credit home loans) and is required in situations where you provide less than 20% down. But once the loan-to-value ratio reaches 78%, PMI is dropped.
Loan-to-value is how much you’ve paid vs how much the original loan was for. For example, say you took out a conventional loan for a 200,000 house. You paid 20,000 down, so your loan-to-value ratio is 90% (180,000 left / 200,000 total). Once you have $156,000 left, you won’t have to pay PMI anymore since your LTV will be 78% (156,000 / 200,000).
In the long run, bad credit home loans can cost more because of mortgage insurance premiums. But up front, they can cost less than starting a conventional mortgage. If you have both options available to you, you might run the numbers for an FHA loan to see what the advantages are for you.
Bad credit home loans allow for low credit scores
It used to be that the lowest score approved for a home loan was 620. But the FHA has changed all that. Today, people can qualify for bad credit home loans with scores as low as 500. But having a higher score still has its advantages. Credit scores matter for the down payment you’re required to pay on an FHA mortgage, and how likely they will approve you (FHA approval may vary).
Here’s how scores affect bad credit home loans. If your score is between 500 and 579, you’ll pay a 10% down payment. Remember, if you pay at least a 10% down payment, you’ll only have to pay the mortgage insurance premium for 11 years.
Bad credit home loans for people with scores above 580 only required a 3.5% down payment. You can pay a larger down payment if you’re able to. If you pay a down payment smaller than 10%, you must pay the MIP for the life of the whole loan.
FHA requirements for bad credit home loans
It’s true that bad credit home loans allow for credit scores as low as 500. But it may be harder to qualify if your score is between 500 and 579. There are many factors that go into the approval process besides your credit score.
First, make sure that the rent you pay now does not differ from your mortgage payment would be with the FHA loan. It’s still possible to disqualify for bad credit home loans. If the mortgage payment would be much higher, lenders may shy away from approving you. That’s because they take payment shock into consideration. Payment shock describes what happens when somebody’s monthly payments suddenly rise. If your income stays the same but your monthly expenses jump up, you must convince the bank you can afford it.
Another thing you should do if you’re shopping for bad credit home loans is keep an eye on the debt you have. If you have a lot of outstanding debt, it might be a good idea to take two years to pay some of it down. When you apply for a home loan, the lender tests your situation like credit bureaus calculate your credit score. A large amount of credit card debt will make your credit score increase, just like it will signal to lenders you might be a risky borrower.
Lenders are still human, though, and they know that your credit score can suffer from something that happened years ago. Maybe you’ve had a higher income for the last couple of years, but your credit score has moved a little. High income is a great asset to have when applying for bad credit home loans since you can prove your ability to make payments.
Speaking of income, you must provide proof of steady employment for the past two years, and you must verify your income through bank statements, pay stubs, and tax returns. To qualify for bad credit home loans, the payments you make on debt (excluding a mortgage) shouldn’t be over 31% of your monthly income. And when you factor your mortgage in (current or future), payments shouldn’t be over 43% of your monthly income. This is another calculation that shows your ability to take on more payments and will help in qualifying for bad credit home loans.
Also, if you’ve filed for bankruptcy, you need to wait at least two years to apply for an FHA loan (they’ll deny you if you don’t). And if you’ve experienced a foreclosure, wait at least three years. While these guidelines hold in most cases, lenders are human and they may make exceptions for people with exceptional circumstances.
Down payment Assistance for bad credit home loans
Another good thing about bad credit home loans is that down payment assistance may be available. A relative can pay part or all of your down payment for you, or you can receive government assistance.
With conventional loans, you’re only allowed to receive a portion of your down payment as a gift. If you put a full 20% down, you’re allowed to use gifts for the full amount. But if you put less than 20% down, you may have to pay at least 5% down yourself.
On bad credit home loans through the FHA, you’re allowed to use gifts for the full down payment no matter the size. So if you qualified for a 3.5% down payment, you could use gifts to cover all of that. Conventional loans only allow you to receive gifts from family members, but FHA bad credit home loans allow you to receive gifts from employers, labor unions, and charities. For example, a monetary gift from a church would not apply for a conventional loan, but it would for an FHA loan.
There are also government-sponsored programs for people who apply for bad credit home loans through the FHA. These vary by state, so check out HUD’s website to see what’s available for you.
You can’t rent an FHA mortgaged home for 12 months
This stipulation may come as a surprise to first time home buyers. If you’re buying a home, shouldn’t you be able to do what you want with it? Well, bad credit home loans work a little differently. If you finance a home through the FHA, you’re required to be the permanent resident of the home for at least one year before renting.
The FHA is a government program designed to assist people in purchasing a home. If you’re intent is to purchase a home to rent out right away, that goes against the intent of the program. Bad credit home loans through the FHA require that you move into your home within 60 days of closing, otherwise, you could violate the agreement.
Conventional loans are more costly at the beginning, while bad credit home loans cost more in the long run. With the possibility for a 3.5% down payment, FHA loans can be very affordable to someone with bad credit.
Diversity of credit counts for 10% of your score, so bad credit home loans can move your score up a few points if all you’ve had is credit card debt. Making regular payments counts for 35% of your score, so current mortgage payments can add more positive weight to that part of your score. Bad credit home loans are a good option for many people. You may get into a home sooner than you would on a conventional loan, and pay less of a down payment.
Another thing to note: people who have credit scores under 500 are eligible for FHA bad credit home loans. However, if you have “nontraditional credit history or insufficient credit” there’s a chance you can meet other criteria. Ask your local FHA specialist to see if that’s the case.