How to Buy a Home With Bad Credit
You might have other options besides a bad credit mortgage
Most institutional lenders and credit unions will tell you that you can't get a loan if your FICO score is under 620, but poor credit is no reason not to get a mortgage.
You can probably get a bad credit mortgage. It's just that the guys you're talking to—the banks and credit unions—don't offer bad credit mortgages, so they won't steer you in that direction. And this might not be your best option anyway.
You might have other alternatives, depending on just how bad your credit is and what went wrong.
Ask for a Referral
Ask for a referral if your regular mortgage broker can't help you. Most lenders who have been in the business for a while also maintain contacts in the subprime market. They can almost always refer you to a lender who can make you a mortgage.
Find a Bad Credit Mortgage Lender
Homebuyers with poor credit can almost always get bad credit mortgages, but they sometimes pay dearly for them. Rates and terms tend to be exorbitant.
Check out the mortgage broker you have in mind with your state's licensing board to make sure that you're dealing with a reputable company. Do not get a hard-money loan through a loan shark. It's easy to get suckered in, so be careful.
It Should Be a Temporary Solution
Think of a bad credit mortgage as a temporary situation if you do end up going this route. Make it short term.
This doesn't mean getting a short-term loan, but rather paying on the loan for no longer than two years or so while you build up your credit. Then, hopefully, you can get a decent refinance at a more affordable rate.
Don't agree to a mortgage with a prepayment penalty if you can avoid it. You could pay as much as six months' worth of additional interest if you pay off the loan early. Most of your early payments are interest, not principal, so that's like making an extra six payments.
Wait It Out and Save Up
You might want to wait three years before applying for a mortgage if you've just completed a short sale because you'll get a much better rate if you wait.
Fannie Mae guidelines say a short sale seller can qualify in four years for a loan as long as the seller maintains good credit after the short sale, or in two years if there are extenuating circumstance. The FHA requires just three years.
You can probably qualify for an FHA loan in a few years even if you've filed for bankruptcy, as long as you keep your credit squeaky clean after the discharge.
You might try to keep your housing costs to a minimum while you're waiting it out so you can save up a more significant down payment. This can help you in three ways: You're more likely to be approved for a mortgage when you put at least 20% down, you'll pay less in interest over the life of the loan, and you'll dodge the private mortgage insurance requirement that will bump up your monthly payments.
Consider an FHA Loan
The Federal Housing Administration insures mortgages, effectively guaranteeing lenders that they'll be paid even if the borrower defaults.
The FHA is somewhat forgiving of credit problems. You can qualify with a credit score as low as 580 if you put at least 3.5% down. Employment and loan-to-value requirements are somewhat less exacting as well. It can be worth checking out.
Lenders are free to place "overlays" on FHA requirements, setting somewhat higher standards for credit scores and required money down, so you might have to shop around.
Consider an ARM
Your interest rate will be lower with an adjustable rate mortgage (ARM) than with a fixed rate amortized loan, and you'll most likely pay lesser discount points, too. This can help keep your mortgage payments manageable, potentially making you less of a credit risk.
The flip side to an ARM is that, as the name suggests, your interest rate can change periodically over the years. Your mortgage payment won't necessarily be the same two years from now as it is today.
An ARM interest rate is tied to the economy, usually based upon the key index rate set by the Federal Reserve. Your lender can make adjustments just once a year, every six months, or even monthly. Your contract should cite the frequency.
You'll typically receive a fixed rate for a period of time at the beginning of the loan, however. An adjustment won't happen immediately.
Work on repairing your credit. Fixing poor credit can take anywhere from a few weeks to a year, but many issues can be resolved within a few months. Simply paying down your credit card debt can bring up your score a little.
Get a free copy of your credit report and examine it. Write to the credit bureaus and ask for a correction if you find a mistake that's dragging down your score. Then ask the lender to check your credit again using a rapid rescore.
Rapid rescoring is a mortgage industry secret tactic. It might increase your FICO score a bit in a relatively short period of time if you're taking steps to repair it.
Credit reporting agencies normally only update your credit once a month. A rapid rescore happens within a matter of days. It's not a guarantee that your credit score will go up, but at least you'll be working with the most recent version of your report.
FHA guidelines allow co-signers, so consider this option. Maybe your parents or another relative would be willing to help you avoid a bad credit mortgage.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.