Sometimes prospective homebuyers get so caught up in how to buy a home with bad credit that they never pause to ponder whether they should do so in the first place.
Don’t get me wrong, homeownership comes with plenty of perks. But it also comes with its own drawbacks, which get far less attention in the aspirational press.
These drawbacks are amplified for homebuyers with bad credit.
As you work through the decision whether to buy or rent given you current credit standing, keep the following pros and cons in mind. Be especially careful not to make the decision emotionally — for most people, their home is the largest asset they own, yet they allow emotions to impact their costliest financial decision.
Downsides of Buying a Home With Bad Credit
Bad credit costs you real money when it comes time to borrow.
But higher costs are only the beginning. Beware of these dangers and downsides as you decide whether to buy or rent your next home.
1. Higher Interest Rates
Borrowers with bad credit can expect to pay more for the same loan amount. It’s a difference often measured in thousands of dollars, both up front and every year thereafter.
For example, a $250,000 loan for 30 years at 3.5% interest costs $1,122.61 per month. At 5% interest, the same loan costs $1,342.05: a monthly difference of nearly $220, amounting to roughly $2,640 more each year.
Over the course of a 30-year loan, the 3.5% borrower pays $154,140 in total interest. Sound like a lot? Consider that the 5% borrower pays $233,138 in total interest — roughly $80,000 more.
And homebuyers can’t necessarily just refinance their mortgage later for a lower interest rate. With interest rates having hovered at historically low levels for years, and then tumbling even further in the coronavirus pandemic, homebuyers can’t expect interest rates to go anywhere but up from here.
2. Inability to Cover Other Costs of Homeownership
The mortgage payment isn’t the only cost incurred by homeowners. You must also pay for repairs, maintenance, homeowners association fees, and other costs of homeownership.
But many homebuyers with bad credit find themselves stretched so thin financially that they can’t afford these other expenses. After putting every cent they have into the down payment and closing costs, they’re devastated when they discover six months later that they need to spend $2,500 on roof repairs.
It’s not only the initial cash layout for the down payment and closing costs that stretch these homeowners. Many find themselves with high monthly payments, due to their higher interest rate. That makes it harder to save money and build an emergency fund for costs like home repairs, medical expenses, auto repairs, and other financial emergencies.
All of this can leave homeowners with less financial security than they had as renters, not more.
3. The Call to ARMs
Often, borrowers with bad credit are tempted by adjustable rate mortgages (ARMs), which are cheaper at first but subject to rate hikes. The temptation is no accident either; lenders love ARMs, because they set up borrowers to need to refinance a few years down the line — which is highly profitable for the lender. So some lenders push these adjustable mortgages on borrowers with bad credit and few other choices.
Typically, ARMs work like this. For an initial period, the interest rate remains locked in at a relatively low rate. Then after a few years, it switches over to a higher interest rate, which fluctuates based on the prime interest rate.
When that happens, borrowers suddenly find themselves strapped with a dramatically higher interest rate and monthly payment. It’s around this time that the lender contacts the borrower, offering to refinance their loan at a lower interest rate — and, of course, charge a new set of lender fees, and restart their amortization schedule. For the borrower, that means starting back at square one for repaying the debt, with most of the monthly payments going toward interest.
4. Higher Lender Fees
Lenders price their loans based on perceived risk. The higher the risk of the borrower defaulting on the loan, the more the lender has to charge to justify their risk.
So they charge higher interest rates, but they also charge more in upfront fees among the closing costs.
A borrower with bad credit may pay two points at closing — a $5,000 cost for the imagined borrower above with a $250,000 loan — compared to no points for a borrower with excellent credit. And if you take out an FHA loan, add another $4,375 fee for the upfront mortgage insurance premium, plus another $177 each month.
Although you may be able to negotiate a seller concession to cover some of your closing costs, those lender fees don’t just go away. Your negotiated deal with the seller nets them a certain amount; they can either accept a lower offer with no seller concession, or require a higher sales price with a concession. Either way, you pay for both the house and the closing costs.
5. Higher Down Payment
Yes, a higher down payment means you need to save up more money, which means it will take you longer to be able to afford to buy a home. But the challenges don’t stop there.
High down payments force you to tie up more of your cash in your home, where you can’t easily access it. That means pumping all your cash into your home rather than investing it in assets that produce passive income or compounding returns. Although homes often go up in value, the house you live in is first and foremost your housing expense, not an investment optimized for its returns.
In other words, all the cash you’re forced to tie up in your home creates an opportunity cost. You can’t invest it elsewhere, such as in an index fund, in the hopes of generating far higher long-term average returns. Instead, your cash is locked as real estate equity, which could prevent you from investing money for retirement, for example, and taking advantage of employer matching contributions. Or perhaps you funnel your extra money into saving up a down payment instead of paying off high-interest debt.
All that money tied up in one asset also means a lack of diversification, in both your asset allocation and net worth. Plus, it’s expensive to pull equity from your home if you need to access it for cash later.
Beyond the opportunity cost, it can also leave you cash-strapped, with little left in your bank account for day-to-day needs or unexpected expenses.
6. Higher Cash Reserves
Lenders sometimes require borrowers to have cash reserves at the time of settlement. They like to see a certain number of months’ payments set aside in cash, to reassure themselves that you’re not spending your last dime to buy a house without an emergency fund.
The worse your credit, the more lenders fret about your ability to repay — and the more months’ payments they’re likely to require held as cash reserves.
7. Possibility of Permanent Mortgage Insurance
Historically, conventional mortgage loans that comply with Fannie Mae and Freddie Mac loan programs were designed for borrowers with at least decent credit. In contrast, FHA loans were designed to help borrowers with bad credit become homeowners.
But there’s a crucial difference between FHA and conventional mortgage loans. Among most conventional loans, borrowers can apply to have their mortgage insurance removed once they pay their loan balance below 80% of the property’s value. However, FHA loans no longer allow borrowers to remove mortgage insurance — they must keep paying it for the entire life of the loan.
With mortgage insurance often costing over $100 per month, that adds up to many thousands of dollars over the life of the loan.
And it doesn’t serve you in the slightest. Mortgage insurance protects the lender, not the borrower. In the event that you default and the lender has to foreclose, mortgage insurance kicks in and reimburses the lender for any losses they incur.
Borrowers with bad credit often see few loan options available other than FHA loans with their famously low down payment and lifelong mortgage insurance requirement.
8. All the Standard Drawbacks of Buying a Home
Homeownership isn’t all backyard barbecues and bedtime pillow fights. It comes with its own risks and downsides, regardless of your credit score.
To begin with, you become responsible for repairs and maintenance, which are neither cheap nor predictable. This year, it could be $5,000 for a new air conditioning condenser. You reassure yourself that your budget got thrown off this year by that “anomaly” AC bill, and that next year will be different. Then the next year you have to shell out $15,000 for a new roof.
With greater irregular expenses comes a greater need for cash savings and emergency funds. Which, in turn, requires greater fiscal responsibility and discipline on your part.
Homeownership also leaves you with far less flexibility to get up and move. If the perfect job offer comes along in another city, renters can get up and leave. Homeowners can’t.
The same goes for having more kids, unexpected deaths in the family, or any other curveballs that come your way and change your housing needs. For that matter, homeowners can’t easily downsize to adjust their living expenses if they lose their job or face some other financial hurdle.
Bear in mind that you take an initial loss when you buy a home, due to the thousands of dollars in closing costs. On top of that, it costs tens of thousands in additional closing costs on the back end when you sell, not to mention months of marketing the property for sale. All of which raise a critical question: how do homeowners make back those losses?
They usually make it back through appreciation, and possibly with savings compared to similar rental costs in their market. But that all takes time, measured in years.
In other words, when you buy a home, you commit to own it for years if you don’t want to lose thousands of dollars in the transaction costs.
Perks of Buying a Home With Bad Credit
All that being said, it’s not all doom and gloom for homebuyers with bad credit. Beyond the advantages below, homeownership gives you near-complete control over your home, from alterations and improvements to bringing in pets without needing a landlord’s permission.
Keep the following in mind as counterarguments to the bitter taste of reality outlined above.
1. Incentive to Improve Your Credit
Bad credit is expensive. Many consumers don’t pay much attention to their credit; some don’t even know their credit score.
But when you start preparing to buy a home, all that changes. The prospect of buying a home incentivizes you to take the reins in improving your credit. Fixing your credit score can save you money not only on your mortgage but also on other secured debts, such as auto loans and personal loans. It also opens doors to you such as cash-back credit cards, which create another level of defense against financial emergencies.
2. Can Improve Your Credit
If you do buy a home, having a mortgage can actually help improve your credit.
After an initial dip from the credit report pull and new debt account, your credit score rises as you pay your mortgage on time every month, building a history of on-time payments. With every month that goes by, it helps boost your credit.
The emphasis is on “consistent on-time payments” though — late payments will wreak havoc on your score.
3. Lower Risk of Becoming Upside-Down
By putting down a larger down payment, you also have a lower risk of becoming upside-down on your mortgage.
Your home could drop 5% in value next year, but if you put down 20%, you still have plenty of equity. The same can’t be said for the high-credit homeowner who only put down 3% — a 5% drop in home value means they now owe more than the house is worth.
Upside-down homeowners can’t sell their house without losing money, often in the tens of thousands of dollars. They face a sour choice of either staying in a home they no longer want to live in or keeping the home as a rental and becoming forced landlords.
When you buy a home with a larger down payment — whether by choice or because your credit situation requires it — you decrease the likelihood of this unpleasant outcome.
4. Formulation of Good Financial Habits
When people set a major financial goal like buying a home, they save money to realize that goal.
That large down payment you need to put down forces you create a habit of saving money each month. It’s a habit you can and should keep, even after buying a home, and one that will help you preserve your improved credit score.
5. Forced “Savings” Through Principal Paydown & Equity
Owning a home creates a forced form of savings. Every month, part of your mortgage payment goes toward paying down your principal balance, creating more equity in your home.
That equity may not be easy to tap into — and all the better. It can grow in the background, out of sight and out of mind, until the day you go to move and realize you have six figures in home equity boosting your net worth.
Once again, the more money you save each month, the better!
How to Fix Bad Credit Quickly
There’s plenty to say about improving your credit. But here are a few highlights to get you started right now.
First, commit to paying every single bill on time, every single month. Although I partially mean committing emotionally, I also mean committing financially: set up automated payments for each recurring bill. Schedule these automated payments to go out on your paydays, so they go out before you get tempted to spend the money elsewhere.
Second, pay down your credit card balances below 30% of each card’s limit. If a card’s limit is $1,000, pay the balance below $300. The credit bureaus reward you with a higher score when none of your rotating credit lines have a balance over 30% of their limits.
Third, pull your credit report and review it for errors. You’d be amazed how often the credit bureaus mess up, but when you think about it, they review trillions of transactions every single month. They’re bound to make mistakes. Fortunately, they also make it extremely easy to fix errors on your credit report for free.
These services will also analyze your credit accounts and let you know if you can establish better credit. People without much credit established can open secured credit cards or “credit builder loans” through services like Self to report their monthly savings to the credit bureaus as though they were loan accounts.
Pro tip: If you’re looking to improve your credit scores, sign up for Experian Boost. Not only is it free, but it can help you improve your credit scores instantly. Experian Boost users have increased their credit scores by 13 points on average.
They say the more you need a loan, the less likely anyone is to lend you one.
Start making yourself a more attractive borrower today, whether you plan to buy a home in the near future or not. Good credit opens doors, giving you the option to take on loans when and if you want them.
And ultimately, in the face of an uncertain future, the best way to prepare is by creating as many options for yourself as you can.
Do you plan to buy a home over the next few years? How has your credit history impacted your decision?