First Time Home Buyers: Buying with Bad Credit
Buying a home has been part of the American dream since the end of World War II. In fact, the postwar economic boom was largely responsible for much of the housing construction explosion that occurred from the 1950s through the 1970s. Yet today, the struggling economy that followed the housing crash of 2007-2008 has made dreams of home ownership dim for many Americans, especially the first time home buyer. Those with bad credit are finding it especially difficult to secure the funding they need to purchase.
If there's any good news in the current housing market, it's the fact that it is still possible to secure a home loan even if you do have bad credit. There are some specific things you need to do, as well as certain disadvantages to securing a home loan with bad credit, but it can be done. We'll do our best to explain it as clearly as we can here as a means of helping you make the decision of whether to purchase now or wait until your credit is better.
The History of Your Credit
The term "bad credit" is a very broad one that does little to define the actual events that might prevent you from securing a mortgage. Typically there are a few different items that would qualify as bad credit if they showed up on your report. They are:
- consistently late or missed bill payments
- foreclosures, repossessions, or judgments
- bankruptcies
- credit over-extension
- unusually frequent credit checks
- multiple denials of credit from other sources
All of these negative things are combined with any positive things in your history to produce what's known as a "credit score." This credit score can be anything from 0 to 880, depending on the scoring system used. The most common system in the American banking industry is called FICO, an acronym for the company responsible for introducing it (Fair Isaac Corporation). This scoring system was developed in the 1950s by an engineer and his mathematician partner who came up with a complex mathematical formula to accurately represent an individual's credit worthiness.
FICO was used in the banking industry only sparingly until the 1990s, when Fannie Mae and Freddie Mac adopted it as the standard for determining credit worthiness for mortgages. As a result it is now the most widely used scoring system for banks and other mortgage lenders.
FICO Score and Your Mortgage
If your FICO score is 700 or better you are considered to have excellent credit. You will get the best interest rates, the best terms, and the most opportunities to borrow money. As your score goes down from there your interest rates go up, your terms become more restrictive, and your opportunities to borrow become fewer. Where mortgages are concerned you can still qualify with a lower credit score but you will most definitely suffer in terms of interest rates.
For example, if your credit score is somewhere around 525 you can expect to pay the prevailing interest rate for someone with excellent credit, plus an additional amount of up to 3.8%. So if the prevailing rate for excellent credit is 5%, you could pay as much as 8.8% interest for your mortgage. Different credit score ranges add different amounts to the prevailing rate for customers with credit that is less than ideal. This is significant when you consider that every quarter-point of interest is worth thousands of dollars over the life of your mortgage.
If your FICA score is not all that desirable and you still want to try to purchase a home, you're probably going to end up being forced into an FHA mortgage. These mortgages are made by commercial banks and mortgage lenders but backed by the federal government in case you default. FHA mortgages are easier to apply for and get than conventional ones, but you'll pay higher interest unless you meet certain low income requirements.
Bankruptcies, Foreclosures, Etc.
If your poor credit history is the result of bankruptcies, foreclosures, repossessions, and the like, it's probably not a good idea to attempt to purchase a home within the first few years after one of those events. Using bankruptcy as an example, federal law dictates you can only declare bankruptcy one time within a seven-year period. However the record of your bankruptcy remains on your credit report for a minimum of 10 years. Finding a mortgage with a suitable interest rate while bankruptcy hangs over your head is very difficult, to say the least. You might be better off waiting a full 10 years and then trying for a mortgage.
Similarly, foreclosures and repossessions carry with them bad marks on your credit report. A typical foreclosure or repossession will be tracked for a minimum of seven years. During that time the credit opportunities you receive are going to be limited and probably not worth your time or effort. Foreclosures are of special concern to mortgage brokers - for good reason. You might do well to follow the same advice after a foreclosure in that you wait the full seven years until it is off the record.
If you decide you cannot wait the full 7 to 10 years after a foreclosure or bankruptcy, there are some things you need to know. For a conventional loan the average minimum waiting period is roughly 4 years. After that you might qualify for a mortgage but it's going to require a significant down payment and you will incur a very high interest rate. For an FHA mortgage the wait is only two years, but income restrictions will be very tight. Whether you get an FHA mortgage or a conventional one, expect a minimum down payment of as much as 35% if you're not willing to wait out the 7 to 10 year time frame.
What to Do While You're Waiting
If you should decide to wait on purchasing a home until you repair your credit you need to be proactive about doing so as soon as possible. Sitting on your hands and hoping your credit will take care of itself is a great way to make sure it never happens. You need to employ some very specific strategies that will engage both your creditors and credit reporting agencies. You need to give both of them a reason to raise your score.
The first thing you need to do is make sure you never make a late payment again. That means setting up a budget and making sure there is money set aside to pay all of your regular monthly expenses. The budget is of utmost importance because it shows you where your money is being spent. If you can't afford all of your monthly bills a budget also shows you the most likely places that can be cut in order to make ends meet.
Once you've established a system of making sure all of your bills are paid on time you can then go about re-establishing good credit. There are several avenues to do this including using secured credit cards, purchasing cars with dealer-financed loans, purchasing household items from rent-to-own stores, and establishing limited amounts of credit at department stores, gas stations, etc. All of these things will contribute to repairing your credit, albeit in small amounts.
Car Loans
We'll use a car loan from a dealer as an example of how this works. You've undoubtedly seen used car salesman in your area with television ads claiming they finance everyone. A good way to start rebuilding your credit is to take them up on the offer. When your car dies and it's time to replace it, visit one of these dealers and purchase your new car from them. They will set up a payment plan which probably will require you to make weekly or bi-weekly payments. As long as you’re faithful to make all the payments on time, they will give a positive report to the major credit agencies.
Secured credit cards are another good way to do the same thing. By making a minimum deposit of $300-$500 you can secure a credit card that you can use for any type of purchase. The smart thing to do is use it for everyday purchases you normally pay cash for, while setting that cash aside in the bank to pay the bill at the end of the month. When your statement comes, simply write a check to cover the full amount and put it in the mail. In doing so, you will be rebuilding your credit without incurring any additional debt.
Conclusions
It is very possible to secure a mortgage even with bad credit. Just understand that it will be more difficult to apply, it will require more of you in terms of resources, and you will pay a higher interest rate. If these things are of no concern by all means go ahead and try. If they are, you should consider taking the time to rebuild your credit before applying for a mortgage.
