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The past several years house values have increased in many parts of the country. Median incomes in the United States have also risen the past four years in a row. If your income is heading higher, or you’re noticing houses are selling for more in your neighborhood, you may be thinking about buying a home, or accessing some of the equity in the house you currently own. The biggest factor that will drive your interest rate and monthly payment will be your credit history.
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Buying or refinancing with bad credit can be challenging, but there are ways to overcome those credit issues if you understand how lenders look at all the parts of your loan application when determining your ability to repay a mortgage loan.
What lenders look at if you are buying a home
- Down payment: This is the amount required for you to “put down” in order to buy the home. The more you put down, the lower your mortgage payment is.
- Debt-to-income ratio (DTI): There are two ratios mortgage lenders look at. Your front-end ratio is your monthly payment on your home divided by your gross income. Your back-end ratio takes all your debt — such as student loans, car loans, credit cards and other monthly debt, as well as your new mortgage payment — and divides it by your gross income. The back-end ratio is the one that has the biggest effect on your loan approval.
- Credit score: In order to determine your interest rate, loan costs and monthly payment, most mortgage lenders will access credit scores from three credit bureaus, and in most cases take the middle of the three scores. The most common credit bureaus used for mortgage credit scoring are Experian, Equifax and TransUnion.
- Type of property: Condominiums, co-ops, manufactured homes and multi-unit properties have different lending requirements. It’s important to let your lender know if you are buying this type of property, as it will affect your ability to qualify, your interest rate, how much down payment is required and the DTI requirement. In some cases, the property itself will have to go through a separate approval process to make sure it meets the lender’s “project” guidelines.
What lenders look at if you are refinancing a mortgage
- Credit score: Much like a purchase loan, your credit score will determine your interest rate and how much you can borrow compared to the value of your home.
- How much equity you have: This is determined by the difference between your current mortgage and the value an appraiser gives your home at the time of your refinance. For example, if you have a $250,000 mortgage and your home appraises for $300,000, you have $50,000 in equity. How much equity you can borrow depends on your credit score, the loan program you are eligible for and your debt-to-income ratios.
- Debt-to-income ratio: Lenders look at the same ratios as they do for purchases. If you are taking equity out of your house with a cash-out refinance, lenders may have stricter requirements for your max DTI to make sure you aren’t borrowing too much compared to what your current monthly payment is, especially if your credit scores are near the minimums.
- Type of property: Condominiums, co-ops, manufactured homes and multi-unit properties will not allow you to take out as much cash. Property type may affect your ability to qualify because of stricter requirements for approval, higher down payment requirements and, often, higher interest rates.
What is the minimum down payment to get a purchase mortgage?
Many people mistakenly believe that the changes to the mortgage market made it necessary to save up 20% to buy a home. Lenders have been gradually easing guidelines, and there are a number of programs that allow for a little as 0% down payment.
- Conventional: Most conventional mortgage programs require at least a 5% down payment. This can be from your own savings, a gift from a relative or a combination of the two.
- FHA: The HUD-insured FHA mortgage requires 3.5% down and allows for credit scores down to 580. It also allows for down payments from gifts.
- VA: Qualified veterans can purchase a home with 0% down with verification that their service meets the requirements for the VA home loan guarantee. If you are a veteran, you can determine your eligibility for VA financing by clicking on the certificate of eligibility for a home loan link.
- USDA: This rural loan program allows for as little as 0% down financing on eligible properties. You can use the online USDA property eligibility tool to find qualified homes.
- HomeReady®/HomePossible®: Both of these conventional loan programs allow for down payments as low as 3%.
- Down payment assistance: Government grants, municipal bond programs and income-based housing assistance may be available depending on your income and where you are buying. It’s best to contact your local government housing or nonprofit housing agencies to find out what might be available.
What is the maximum I can borrow for a cash-out refinance mortgage?
- Conventional: Conventional mortgage programs allow you to borrow up to 80% of the value of your home and don’t restrict what you use the cash out for.
- FHA: The FHA mortgage is a government loan program that allows you to access up to 85% of the value of your home and does not restrict how you use the cash out.
- VA: Qualified military veterans can borrow up to 100% of the value of their home, and there are no restrictions on the use of the cash out.
- USDA: The USDA loan program does allow cash out up to 100% of the value of the house, but only for repair or remodeling of the home. Since the funds have to be provided to a contractor, this is considered more of a construction loan than a cash-out refinance. All funds must be paid to contractors for the repair or construction work.
What is the minimum income needed to get a mortgage?
While most people assume their credit is the most important factor in getting approved for a loan, debt-to-income ratio has the biggest effect on a lender’s decision to make a loan. Lenders look at the total amount of debt plus your mortgage payment divided by your gross income very seriously to make sure you will be able to repay your mortgage.
- Conventional: The standard qualified mortgage guideline is 43% DTI (back end), although many lenders approve borrowers with a 50% back-end DTI with additional compensating factors (there’s more on that in the next section).
- FHA: The back-end ratio guideline for FHA is 43%, although loans are approved over 50% with additional compensating factors.
- VA: VA does not have a maximum qualifying debt ratio, but rather a residual income test borrowers must meet in order to qualify for a loan. This calculation is based on a veteran’s family size and varies by location. The calculation starts with after-tax income and subtracts all debt and a maintenance-and-utility calculation based on the size of the home. If the veteran meets the requirement, the loan can be approved, even with very high debt ratios.
- USDA: Front-end/back-end DTI maximums are capped at 29%/41%, with exceptions to 32%/44% with compensating factors.
- HomeReady/HomePossible: The guideline maximum back-end DTI is 50% based on automated underwriting guidelines. The HomeReady program has income limits, but the HomePossible program does not. Be sure to check with your loan officer for the income limits in your area.
- Down payment assistance: The DTI requirements vary by state and program, so it’s best to contact your local nonprofit or government housing agency to find out what they are in your area.
What is the minimum credit score to get a mortgage?
Many current and aspiring homeowners are surprised to learn that they can get approved for mortgage financing with scores as low as 580 and very little down payment. They are equally as surprised by how much more the monthly payment and closing costs are as a result of their low credit scores.
Refinancing with bad credit costs a lot more in the short and long run — the more you borrow compared to the value of your home, the higher the interest rate is going to be, and the more you’ll pay over the life of the loan. It’s very important to do a cost-benefit analysis with your mortgage loan officer to discuss the financial goals you are trying to accomplish with a refinance, especially if you have bad credit.
Below is a graph showing the effect of credit scores on interest rates for consumers who received loan offers through the LendingTree marketplace in October 2018. (LendingTree is MagnifyMoney’s parent company.)
|FICO Range||Average APR||Average Down Payment||Average Loan Amount||Average LTV||Lifetime Interest Paid*|
*Lifetime interest paid is calculated based on the overall average loan amount to enable comparison.
Even though borrowers with scores as low as 620 received mortgage offers, the amount of interest paid went up $23,954 for the life of the loan versus borrowers with scores of at least 680.
The minimum credit score requirements for purchases and refinances are the same. Some lenders may require higher minimum credit scores if they don’t specialize in a certain kind of mortgage program (like an FHA or USDA loan), so be sure to shop around if you are being told that your scores are too low for a particular type of mortgage loan:
- Conventional: 620 is the standard minimum for Fannie Mae and Freddie Mac conventional mortgage loans.
- FHA: FHA loans will require a 580 FICO score for most purchase and refinance loans. Exceptions can be made for scores as low as 500, but these will require higher down payments for purchase loans, and a higher amount of equity for refinances.
- VA: Unlike the other programs listed here, the VA does not have an actual published minimum credit score requirement. Most lenders will require a 620 FICO score, although like FHA, exceptions can be made for borrowers with higher down payments or more equity.
- USDA: Most lenders will require a 640 score, although exceptions can be made down to 580.
- HomeReady/HomePossible: This program requires a 620 score minimum, but some lenders may require higher score limits.
- Down payment assistance: Most down payment assistance programs will require at least a 640 credit score, but you’ll want to check, as the guidelines for these programs change frequently.
Ways to overcome credit score weakness: compensating factors
If you’ve been told that you have a low credit score, take heart: Lenders look at more than just your credit score when making mortgage loans. There are a number of things that you can provide to compensate for a weak credit history, and many lenders are willing to take a second look at a loan application they initially rejected if you can provide proof of some of these items.
Keep in mind that lenders are looking at what they call “layers of risk.” That means if you only have one layer — bad credit — but have other good layers, like a stable income and savings, you may still be able to secure approval.
Lower debt-to-income ratios and long-term job stability: If you are able to borrow below the maximum debt ratios, and have at least two years in your current job, you will have a better chance of getting approved, even if your credit scores are near the minimums. This might mean you have to buy a little bit less of a home, so keep that in mind if you are starting the house-hunting process knowing you have some credit problems.
Extra reserves and savings: Extra savings, in addition to other retirement savings, can help offset a bad credit history. These are commonly referred to as “payment reserves” and show the lender that if you had to, you could use these funds to pay your mortgage for a certain time period after closing. Be sure to provide all of the assets you have — that cash-value life insurance policy your grandma got you when you were 18 may come in handy, and any 401(k)s can be used toward a reserve requirement (they don’t have to be liquidated).
Having your own down payment versus a gift of down payment assistance: If you can save your own down payment, it will help show you have already made a financial commitment toward the house.
Minimizing credit use 60 to 90 days before you apply for a mortgage: Hold off on buying that brand new car, and limit your credit use to small purchases on credit cards for 60 to 90 days before you apply for a mortgage.
Credit repair: There are a variety of credit repair companies that can help you, but it may take three to six months, and there is usually a monthly cost involved. Some lenders may suggest rapid rescoring — especially in cases where you may have paid down a balance recently, but it hasn’t reflected on your credit report yet. This allows for corrections to your credit card balances that are reflected within five to seven days, instead of the normal 30 to 60 days it may take a credit repair company to correct the information. As with any financial product, be sure to shop around.
Are there other options for refinancing or buying with bad credit?
If you aren’t able to get a mortgage using the compensating factors outlined here, there are lenders that are beginning to offer programs referred to as “non-QM,” ”non-Dodd Frank” or “alternative” loans.
They allow for borrowers who have had major credit events like recent foreclosures or bankruptcies to borrow money at much higher rates. In most cases the down payment requirement is at least 10%, but usually up to 30% for very low credit scores. For refinances, you’ll be capped at much lower maximum loan amounts, which means less cash back to you.
Be sure to discuss an “exit” strategy with your loan officer if you decide to get this type of loan, so that you can be in a more traditional program with a refinance or pay the entire loan off within a couple of years.
Be sure to get second, and third, opinions
There are many different lenders offering a variety of programs to overcome credit challenges.
Before you apply, compare mortgage offers online so you can see what your payment will look like based on your current credit score.
Whatever your situation, be sure to explain all the details to your mortgage professional, and be prepared to provide supporting documents. If you can show that you understand what caused the credit issues and provide proof of the other good things going on with your income and assets, a lender may be willing to consider your refinance or purchase mortgage application for approval.