If there’s ever a moment in life when you suddenly become aware of credit, it’s when you’re ready to buy a home. Suddenly the score you’ve been hearing about for years holds the keys to your dream home — and can easily determine whether or not you’re going to get it.
Unfortunately, the day you decide to apply for a mortgage typically comes after the time when you ought to have been thinking about credit. But that doesn’t mean you’re totally out of luck if you’ve found the house you want and just recently discovered that your credit could use some renovation itself.
Here’s how to buy a house if you have bad credit.
How to Buy a House if You Have Bad Credit
Look Into an FHA Loan
One option for those with less-than-perfect credit is what’s called an FHA loan. This is a loan that’s backed by the government and given with more favorable lending conditions. In other words, you won’t have to come up with as much of a down payment, you’ll pay lower closing costs, and you don’t need to have pristine credit to be approved.
Some downsides are that you’ll have to pay mortgage insurance, which is an added cost that doesn’t go to helping you pay down your mortgage. That said, if it’s the difference between being able to buy a home and not, it might be worth it.
In order to get this type of mortgage, you must go through FHA-approved lenders. You can find a list of such lenders via the Department of Housing and Urban Development.
Consider Rent-to-Own Homes
Although not as common as FHA loans, another option for buyers with imperfect credit is rent-to-own homes, which you can find with the help of your local realtor.
These homes start off with a rental agreement, which means your credit doesn’t need to be as good for approval as it would need to be for a mortgage. This works sort of similarly to a car lease — you have an option to buy at the end of your term (which can often last about three years) but you aren’t always required to. You’re also not guaranteed approval if you choose to buy.
Other details can vary, as rent-to-own homes don’t have regulated agreements. One thing you’ll likely encounter is an option fee, which is a down payment you make in order to eventually have the option to buy the home. Some of that fee could be applied to your home purchase later, but the amount will depend on your agreement.
Another is something called a rent premium, which is the amount you pay in addition to your rent each month. It’s then put into escrow to be used should you decide to purchase the home. It’s important to know that your seller might be able to keep these premiums if you decide not to buy, so read your agreement carefully before signing.
Rent-to-own homes are not without risk. But they can be helpful in that they give you a few extra years to save for a downpayment on a home and improve your credit, all the while enabling you to work towards ownership of the home you’re in.
Find Seller-Carried Financing
Some private home sellers offer their own financing. There are many variations on what this is called, including “seller-carried financing,” “seller financing,” “seller carry-back mortgages,” and “carry-back financing.”
This type of financing can work to your benefit or not, depending on the seller. Some might be more forgiving of imperfect credit, while others might be stricter about who they’ll accept since they stand to take on a lot more risk than a bank would.
Like rent-to-own agreements, you can ask your local realtor for help finding sellers who offer their own financing.
Get a Cosigner
As with all loans or lines of credit, one way to get approval when your credit isn’t great is to add someone to the deal who has better credit than you. As soon as that person is included in the application, your odds of approval can go up.
That said, it’s a huge responsibility for your cosigner. If you default on your payments, they have to pay. And if they can’t, both parties’ credit will take a hit and the home can be taken away. In addition, a cosigner is a partial owner of the home, which might not be a risk you’d like to take on. If you proceed with this option, consider choosing someone you trust unfailingly.
If you go this route, know that there are two types of cosigners: Non-occupant co-borrowers and occupant co-borrowers. Make sure you’re honest about the type of cosigner you’ll have on your application, as that will change how some of the process works both before and after the deal is done.
Improve Your Credit Utilization Ratio
If you have a few months before you absolutely need to close on a mortgage, one of the best options you have is to work on improving your credit score. Doing so improves your chances of approval for a traditional loan, and it helps decrease the interest rate you’ll likely pay.
So how can you quickly boost your score? Pay down any debt you’re carrying — especially credit card debt. Easier said than done, for sure, but a focus on getting your balances to below 30 percent of your total limits can help your score quite a bit.
On the same note, you can ask your credit card issuers to increase your credit limits. That will automatically decrease your credit utilization ratio (the difference between the amount you owe and the amount of credit that’s available to you) and have the same effect on your credit score as debt paydown.
Want to go for the double whammy? Do both of these things and get a huge boost to your credit score.
Get Help With Your Down Payment
A solid down payment is a great way to get yourself into a new mortgage, but with today’s home prices it can also be a large barrier to home ownership. That’s why there’s a new trend of companies popping up who offer to help you with your down payment.
These “home equity sharing” companies offer to match what you have to pay for a down payment, enabling you to double your down payment. That helps you get approved for a mortgage and can reduce your monthly payments. In return, they get part of the profit when you sell if your home’s value increases after taking out the mortgage.
Another potential benefit of partnering with one of these companies is that getting a higher down payment can mean avoiding expensive private mortgage insurance (an added expense that doesn’t help you pay down your mortgage debt at all). Two such companies offering these services are Unison and Own Home Finance.
Beware the Payments Puzzle
Whenever you walk into a financing situation, it’s important to do the math on your total budget and how that maps out to monthly payments once interest is added in. There are times when, during this process, you might be told you can “afford” more than you thought.
But just because you can manage a monthly payment on a house that’s more expensive than you planned doesn’t mean you should immediately jump into that higher price range. The fact still remains that you’ll be paying the principal balance plus interest on a mortgage. If you start with a higher principal balance, then you’re already increasing your total budget, and you’ll be paying more in interest overall.
There are times when being able to afford the monthly payment on a house that’s over your budget is a pleasant surprise — but there are also times when it can turn into price creep that you might not be pleased about later. As long as you understand that there’s more to a mortgage than the monthly payments, then you will be better equipped to make an intentional decision on whether or not you should stick to your original budget.
Fix Errors On Your Credit Report
Finally, something you should do before a mortgage no matter what else you do to get a home with bad credit: fix errors on your credit reports.
It’s not at all uncommon to find errors on your credit reports, and these errors can drag your credit scores down due to no fault of your own. To prevent this problem, read your credit reports each year (you can get them for free once per year at AnnualCreditReport.com) and dispute any errors you find.
FREE TOOL: Are mistakes on your credit report hurting your credit score? Find out here.
Make Sure You Never Have to Worry About Credit Again
Although there are options available to those whose credit isn’t up to par, there’s nothing better than being able to easily get credit when you need it and at an inexpensive price (i.e. a low interest rate). And that requires staying on top of your credit game.
After you’ve completed your home purchase, start taking steps to improve your credit so you’ll never again worry about being ready for whatever’s on your financial wish list. The good news is, making on-time payments on that new mortgage is one way to naturally boost your score.
Add in things like keeping your credit card debt as low as possible (with zero being ideal) and never missing payments on any of your bills, and you’ll be on the road to better credit in no time. It doesn’t take much to boost your score as long as you stay on top of it.