You've decided to make the transition from renter to homeowner, but everywhere you turn to for a loan, you're denied. You haven't been the most responsible with money in the past, and now your low credit score is putting your dream of home ownership in jeopardy. But don't give up just yet.
It may not be possible for you to get a mortgage, depending on how bad your credit is, but there are some things you can do to improve your odds. Here are a few steps you can take to give yourself the best chance of approval.
Know what you can realistically afford
When evaluating your mortgage application, lenders look at your income and credit score to ensure that you'll be able to pay back the money you borrow. If you make $30,000 a year, and the home you're interested in costs $2 million, you won't find any lenders willing to work with you, no matter how good your credit is.
As a general rule, the total monthly cost of your mortgage payment, property taxes, and insurance should not exceed more than 28% of your pre-tax income, and your combined monthly payments across all your outstanding debt should not exceed more than 36% of your pre-tax income. By staying within this range, you give yourself the best chance of mortgage approval. You can use our new-house calculator to estimate how much house you can afford.
The definition of poor credit is somewhat arbitrary. Some lenders may consider any score under 630 to be bad, while others may apply that label to anyone with a score under 650. If you're on the bubble, it's a good idea to shop around and see if other mortgage lenders are willing to offer you a better deal.
It's important to submit all of your applications as close together as possible, though. Each application triggers a hard inquiry on your credit report, which will lower your score by a few points. However, credit scoring models typically count all inquiries that take place in a 45-day period as a single inquiry so that shopping for a loan won't hurt you as much.
Get an FHA loan
Federal Housing Administration (FHA) loans tend to have looser credit requirements, and they require smaller down payments than traditional mortgage loans. If your credit score is above 580, you can put as little as 3.5% down at closing. You can still get an FHA loan if your credit score is as low as 500, but you must put 10% down if your score is under 580.
Your mortgage lender may also cover closing costs on an FHA loan, but then you will typically pay a higher interest rate over the lifetime of the mortgage. You will also have to pay for private mortgage insurance (PMI) if you put less than 20% down. Check with your local bank or credit union to see if it offers FHA loans and inquire about how much you can expect to pay per month and at closing.
Make a larger down payment
The larger your down payment, the better your chances of mortgage approval -- because a larger down payment lessens the risk to lenders by lowering the amount of money you need to borrow. An down payment of 20% of the home's value is the gold standard, and if you can pay at least this much, you'll get better interest rates and won't have to pay any PMI.
But not everyone can afford to pay 20% up front. In that case, put down as much as you can comfortably afford. Even if it's just a few thousand dollars above the required minimum down payment, it will show lenders that you're committed to the home and willing to make a significant investment, and this can increase your odds of success.
Get a cosigner
If you have a family member who's willing to go in on the home with you, you can get them to cosign on the loan. They're essentially vouching for your credibility, and if for some reason you fail to keep up with the mortgage payments, they will be held responsible for them. When you have a cosigner on a loan, the lender will look at their credit as well. If it's good enough, you may be able to get a mortgage that you wouldn't have been able to qualify for on your own.
You shouldn't ask someone to cosign for you if you doubt your ability to keep up with the payments. If you fall behind, this will place a financial burden on your cosigner and could potentially damage your relationship. Before you apply for the loan, it's important to sit down with your cosigner and talk about the terms of the agreement and what you would do if for some reason you were unable to make the payments yourself.
What to do if your application is still denied
If you've tried one or more of the steps above and your mortgage application is still denied, you may have to work on improving your credit before you reapply. The first step is to pull your credit reports and check them for errors. Contact the relevant credit bureau and financial institution if you notice any mistakes. Then look for ways to bring your score up.
Make all of your monthly payments on time and work on paying down any debt you have. You may also want to apply for a secured credit card or become an authorized user on someone else's card so you can begin to establish a good credit history.
Getting a mortgage with bad credit is challenging, but it's not impossible. By working to rebuild your credit and following some of these steps, you can give yourself a much better chance of approval.