Just because you have bad credit doesn’t mean you don’t dream of owning your own home.
You can absolutely buy a house, even with bad credit. But the worse your credit, the more challenges you’ll face in buying a home.
As you start exploring the path to homeownership, watch out for these credit-related pitfalls along the way, and follow the steps below to make your dream of homeownership a reality.
How Bad Credit Impacts Your Ability to Buy a Home
First and foremost, understand that lenders price loans based on perceived risk. For them, your loan is an investment. And the higher the risk of the investment, the higher the return they need to justify the risk.
Borrowers with bad credit represent a higher risk for the lender, so they’re charged accordingly. Lenders stop at pricing, either — they also require additional safeguards to protect against default.
For context, credit scores under 630 are typically considered “bad,” while scores in the 630 to 689 range are considered “fair.” Scores in the 690 to 730 range qualify as “good,” and most lenders consider scores above 730 to be “excellent.”
Here’s what you can expect when you approach mortgage lenders as a borrower with bad credit.
Higher Interest Rates
You know all those absurdly low interest rates you see advertised on website banners and mortgage ads on TV?
You won’t qualify for those.
Higher pricing for your loan starts with a higher interest rate. Forget the low rates you see advertised and expect to pay one or two percentage points higher, if not more.
But this doesn’t mean you should settle for whatever the first lender quotes you. Shop around, compare quotes, negotiate, and follow other steps to get a lower mortgage interest rate.
Mortgage lenders charge a lot of upfront fees, most of them flat fees with names like “processing fee,” “administrative fee,” and “underwriting fee.” But there’s one fee type that varies: the origination fee.
Better known as “points,” this fee is a percentage of the total loan amount. One point equals 1% of the loan.
When dealing in figures in the hundreds of thousands, one percentage point is no small sum. Two points on a $250,000 mortgage means an origination fee of $5,000 paid to your mortgage lender. And that’s before all the flat fees and other closing costs.
The bad news is that the worse your credit, the higher the points your lender is likely to charge. The good news? Like everything else in life, points are negotiable. You can and should negotiate aggressively to lower the points charged on your mortgage.
Higher Down Payment
As you probably suspected, lenders typically require borrowers with bad credit to come up with a larger down payment.
Historically, the classic down payment on homes is 20%. Even after tightening loan requirements in the wake of the housing crisis, many lenders still offer loan programs with lower down payments — even for those with bad credit.
Still, you face a harder time qualifying for programs with low down payments as a borrower with bad credit. More on these programs shortly.
Higher Cash Reserves
Some lenders require cash reserves to be held in your bank account, even after the down payment and all closing costs have been paid.
Measured in a certain number of monthly mortgage payments, cash reserves vary from program to program and lender to lender. The worse your credit, the more likely the lender will require additional cash reserves held in your bank account.
Risk of Permanent Mortgage Insurance
If you end up taking out an FHA mortgage — a program specifically designed to help borrowers with bad credit buy a home — it comes with a nasty downside. Borrowers must pay extra for mortgage insurance for the entire life of the loan.
Mortgage insurance isn’t cheap. Borrowers pay a one-time fee of 1.75% of the loan amount, plus annual fees of anywhere from 0.45% to 1.05% of the loan amount (most often 0.85%).
For a $250,000 loan, if you pay the 0.85% rate, that means an extra $4,375 fee at closing, plus $2,125 per year ($177 per month).
By contrast, conventional loans allow you to apply to remove mortgage insurance once your loan balance drops below 80% of the property’s value. And many conventional loan programs don’t require an upfront fee for mortgage insurance.
How to Buy a Home With Bad Credit
Ready to start actively laying the groundwork to buy a home, despite a patchy credit history?
You have more tools, resources, and options available to you than you may realize. In many cases, simply preparing to buy a home will put you in a far stronger financial position.
Here’s where to start in your quest to become a homeowner.
1. Pay Down Unsecured Debts
Aside from the fundamental practice of paying all your bills on time, the first step to improving your credit is paying down your existing balances. In particular, the credit bureaus like to see all of your credit balances below 30% of the account limit.
So, if you have a credit card with a $10,000 limit, you want your balance below $3,000.
For many would-be buyers, this creates a conundrum, forcing them to choose between paying down debts and saving for a down payment. Paying off high-interest unsecured debts must take priority to get your balances down below 30%, at a minimum.
Ideally, you want to pay off all of these debts using the debt snowball or debt avalanche methods and rid yourself of the payments once and for all. That leaves you in a far better position to save money.
Finally, keep in mind that lenders will look at your debt-to-income ratio, including all your debts. It’s called a “back-end ratio” in the mortgage world — the ratio of all your monthly debt payments to your total income.
2. Check Your Credit Report & Dispute Errors
One of the fastest ways to improve your credit score is to remove errors from your credit report.
The credit bureaus process billions of transactions every month for hundreds of millions of Americans. At that volume, mistakes are inevitable.
Start by pulling your credit report and checking every account and reported payment carefully. If you see anything that looks out of place, follow up on it. Contact the creditor, and file a dispute with each of the credit bureaus reporting the error.
Depending on the errors, removing them could cause your credit score to jump by dozens of points within a month or two.
3. Get Aggressive on Saving Money
You already know you’ll need money for a hefty down payment. That means cutting your expenses and maximizing your savings rate. Although the first month or two on a new budget can be a challenge, it’s extremely gratifying when you watch your savings account balloon in value.
One way to subtly trick yourself into saving more money is to label your savings account something like “House Fund.” Every time you transfer money into it, you’ll feel a small thrill for getting closer to your goal of buying your own home.
You can also make saving money easier by automating it through savings apps. They’ll save money for you in the background without you having to lift a finger.
4. Explore FHA & VA Loans
If you’ve served in the U.S. armed forces, check to see if you qualify for a VA home loan. Because they’re subsidized by the Department of Defense, they’re typically the best loan deals available on the market.
Alas, they’re not available to most of us. If you’ve never served in the military, consider an FHA loan. It’s one of the most common routes taken by homebuyers with bad credit.
On the plus side, FHA loans only require a small down payment. Buyers with a credit score above 580 can finance 96.5% of the purchase price, leaving a minimum down payment of 3.5%. Even those with scores between 500 and 579 can buy with 10% down, which is still far less than the traditional 20%.
The major downside is the mortgage insurance premium (MIP), as outlined above. Borrowers must pay the 1.75% upfront fee, plus the ongoing monthly MIP payment for the entire life of the loan. No matter how low you pay down your balance, you still owe it.
5. Don’t Give Up on Conventional Loan Programs
While conventional loan programs traditionally steered clear of borrowers with bad credit, government-sponsored enterprises Fannie Mae and Freddie Mac have introduced conventional loan programs with looser requirements.
Fannie Mae’s HomeReady program is designed more for low down payments than it is for bad credit, but its minimum credit score is a generous 620. With a minimum down payment of only 3% and no life-of-loan mortgage insurance requirement, it makes a great alternative to FHA loans — if you can qualify for it.
Similarly, Freddie Mac offers its own 3%-down loan program called Home Possible. The credit requirement is a bit higher at 640, so keep working at improving your credit if yours isn’t there yet.
If you’re unclear on the difference between FHA and conventional loans, they’re loan programs outlined by different branches of the government. Most mortgage lenders offer both FHA and conventional loan programs specified by Fannie Mae and Freddie Mac, so talk to a range of lenders to compare price quotes.
6. Check With Credit Unions & Community Banks
Sometimes local credit unions and community banks offer appealing loan programs, even for borrowers with bad credit.
These vary wildly from bank to bank, so unfortunately, you just have to pick up the phone and start dialing. Talk to as many local banks as you can, be candid about your credit history, and see what they have to offer.
7. Consider Your Roth IRA
Although raiding your retirement accounts to buy a house isn’t generally recommended, it’s an option on the table.
You can withdraw contributions from your Roth IRA at any time, for any reason, without penalty. And you can even withdraw earnings on those contributions to buy your first home — up to $10,000 if your account has been open for at least five years. There’s no penalty and no taxes owed.
There is one caveat: You must use the withdrawn funds for your home within 120 days of withdrawing them, or else you face taxes and a 10% penalty.
With a bad credit score, you’re looking at a higher down payment, which can feel impossible. Getting a little help from your Roth IRA is one option to bridge the gap, but it comes with the risk of regretting the move come retirement.
8. Accessing Other Retirement Accounts
Again, withdrawing early from retirement accounts is not usually recommended. But if you must break your piggy bank to buy a home, you can do it in a pinch.
You can withdraw up to $10,000 from your traditional IRA, SIMPLE IRA, or SEP IRA to buy a home without incurring the 10% early distribution penalty. Unlike pulling money from your Roth IRA, you do need to pay income taxes on the withdrawn funds. You dodged those income taxes when you contributed the funds.
As with a Roth IRA, you must use the funds for your home within 120 days of withdrawing them.
Your options are more limited with a 401(k). Most 401(k) administrators let you borrow money against your balance, but you still need to pay interest on the loan. Generally, mortgage lenders require that no part of the down payment be borrowed.
One other option is to roll a 401(k) account over to an IRA if it’s with a previous employer, not your current employer. That way, you can access the money using the $10,000 homebuying exemption outlined above.
But only raid your retirement account as a last resort.
9. Get a Cosigner
If lenders turn you down or quote you outrageously high interest rates and fees due to your poor credit, one option is to bring on a cosigner.
It’s a common enough phenomenon with younger homebuyers, who perhaps haven’t established enough credit to qualify for a strong mortgage. Their parents often cosign on their behalf.
But cosigning a mortgage for someone else comes with plenty of risks. It’s a big favor, and not one you should ask for lightly.
10. Prepare All Documentation
When you start contacting lenders to collect quotes, they’re going to ask for documentation. And then more documentation. And still more after that.
Lenders want to see your income documentation, of course, such as pay stubs and several years’ tax returns. They also typically require several months’ bank statements. If you have any large deposits beyond your paychecks showing, they’ll ask about them.
Then they’ll ask for documentation regarding your rental history, and perhaps proof you’ve paid your rent on time.
There is a slew of other documents they might request. Familiarize yourself with the standard closing process and documentation, then prepare to provide a bunch of other documents based on the underwriter’s whims.
Bad credit is the first strike against you. Don’t add any more by failing to produce documentation lenders request.
Even people with poor credit can buy a home. But that doesn’t necessarily mean they should.
Being a homeowner requires far more financial discipline than renting. Every year, you can expect to shell out significant money for maintenance and repairs. Too many homeowners fall into the trap of not budgeting for home repairs, thinking, “This year was different because I had that furnace repair. But next year I’ll be in better financial shape.”
Next year, it will be the roof. Or the plumbing, wiring, or air conditioning condenser.
If you can’t keep four digits in a savings account, you probably aren’t ready to be a homeowner. Start by paying off your credit cards and other high-interest debts, clean up your credit history, and save at least 10% of every paycheck (preferably much more).
A curious thing happens as you start preparing your finances to buy a home. In the process of improving your credit and saving up a down payment, it forces you to improve your financial habits. By the time you pay off high-interest debts and save up a hefty down payment, you should have the budgeting tools and habits necessary to be a responsible homeowner.
As so often happens, the journey prepares you for the destination.