Obtaining Real Estate Financing With a Low Credit Score
Bad Credit Mortgages
The bad credit mortgage is often called a sub-prime mortgage and is offered to homebuyers with low credit ratings. Due to the low credit rating, conventional mortgages are not offered because the lender sees this as the homebuyer having a larger-than-average risk of not following through with the terms of the loan. Lenders often charger higher interest rates on sub-prime mortgages in order to compensate for the higher loan default risk that they are taking.
The following table displays current conforming rates for people with prime credit scores. If you have a poor credit score you can expect to pay a significantly higher rate of interest on your loan the loan is more likely to be structured as an adjustable-rate rather than a fixed-rate. The table also offers a credit score filter which allows you to find offers matching your FICO credit range.
Ways Subprime Mortgages Differ
Subprime have interest rates that are higher than prime loans. Lenders must consider many factors in a particular process that is called “risk-based pricing,” which is when they determine the terms and rates of the mortgage. Sub-prime rates will be higher, but it is the credit score that determines how high. There are also other determining factors like what kinds of delinquencies are recorded on the borrower’s credit report and the amount of the down payment. An example is the fact that the lender views late rent or mortgage payments as being worse than having credit card payments that are late.
In some cases borrowers may take a higher interest second mortgage to help qualify for a lower cost first mortgage.
Sub-prime loans are very likely to have a balloon payment penalty, pre-payment penalty, or penalties for both. A pre-payment penalty is a charge or fee that is placed against the homebuyer for paying off the loan before the end of the term. This early payoff can be because the borrower sells the home or they refinance it. A mortgage that has a balloon payment means that the borrower will have to pay off the entire balance in one lump sum after a specified period has gone by. This period is usually five years. If the borrower is unable to pay the whole balloon payment, they must refinance, sell, or lose the house. If a first time home buyer is working with a non-traditional lender it is typically worthwhile to have a legal and financial expert review the paperwork before signing the application.
A Closer Look at Credit Scores
Credit scoring is the method in which credit risk is assessed. It uses mathematics to determine a person’s credit worthiness based on their current credit accounts and their credit history. The system was created in the 1950s, but did not see widespread use until the last couple of decades.
Credit scores are numbers reported that range from 300-900. The higher the number is, the better the score. Creditors see this number as an indication of whether or not an individual will repay money that is loaned to them. The scores are determined by looking at the following data:
- Late payments
- Non payments
- Current amount of debt
- Types of credit accounts
- Credit history length
- Inquiries on the credit report
- History of applying for credit
- Bad credit behavior, which can be something such as writing bad checks
The score that creditors like to see is above 650, which is a very good credit score. Those who have credit scores of 650 and above will have a good chance of acquiring quality loans with excellent interest rates.
Scores between 620 and 650 indicate that a person has good credit, but does indicate there might be potential trouble that the creditors may want to review. A creditor may require the applicant to submit additional documentation before a loan will ever be approved.
When scores are below 620, the consumer may find that they can still acquire a loan, but the process will take longer and involve many more hurdles. Below this number indicates a greater credit risk, so more aspects have to be reviewed.
Verify There Are No Outstanding Errors
Many people have issues on their credit report which they are unaware of. Identity theft is a common problem in the United States consumer debts are frequently sold into a shady industry. The first step in determining if you have any outstanding issues is to get a copy of your credit report. AnnualCreditReport.com allows you to see your credit reports from Experian, Equifax TransUnion for free. While many other sites sell credit reports and scores, a good number of them use negative billing options and opt you into monthly charges which can be hard to remove. If you find errors in your credit report, you can dispute them using this free guide from the FTC.
Candidates for Bad Credit Mortgages
Some people with poor credit profiles or a small down payment may have trouble borrowing from conventional lenders. One alternative to consider is obtaining a Federal Housing Administration loan. These loans have liberal underwriting requirements which allow people to purchase a home with a poor credit score and as little as a 3% down-payment. Some FHA borrowers have credit scores below 620. Veterans may want to explore low-cost VA loan opportunities.
Another common loan type among subprime borrowers is the 2/28 ARM, which offers a 2-year teaser rate and then adjusts yearly beyond that. Many of these loans have a sharp increase in rates at the 2-year point, with the home buyer planning on refinancing at that point. However if the homeowner still has outstanding credit issues or the mortgage market tightens up then they might not be able to refinance. The higher rate can cause a prohibitively higher monthly payment, an inability to refinance can mean a loss of home ownership.
The below items are the general guidelines that can be used as a rough rule of thumb when determining whether a consumer may be a candidate for a bad credit loan:
- A credit score below 620
- Two or more delinquencies of 30 days on a mortgage in the past 12 months
- One delinquency of 60 days on a mortgage in the past 12 months
- A charge-off or foreclosure within the past 24 months
- Bankruptcy within the past 24 months
- Debt to income ratio is over 50%
- Inability to cover family living expenses in the course of a month
However, overall creditworthiness is not determined exclusively by credit scores. A couple of missing credit card payments does not mean that a consumer is doomed to receive double-digit interest rates. The only way to know where one stands is to apply for the loan and speak to a professional specializing in mortgage loans.
Information for Couples
Joint borrowers applying for a mortgage together may pay a higher interest rate than they would individually. If one person has a significatnly lower FICO score than their partner, the loan officer will likely offer a higher interest rate based on the lower FICO score. In many cases it would be more advantageous for the individual with a higher credit score to apply individually. The Washington Post recently highlighted an example :
A $300,000 30-year fixed-rate mortgage in Illinois, underwritten using a 760 FICO might have qualified for a 3.3 percent rate quote and a $1,309 monthly payment of principal and interest at the beginning of April, according to Myfico.com. If the application were instead underwritten using a score of 650, the rate quote might be around 4.3 percent with a $1,485 monthly payment. Annualized, that comes to $2,112 in higher costs — in this case solely because the couple opted for a joint application and the 650 score raised the rate.
To get around the above issue, the person with a higher FICO score needs to apply for the loan individually and have sufficient personal income to qualify for the total loan amount .
Ways to Improve Your Credit Score
The following are simple ways to improve credit scores
- The number one method is to pay bills on time. Delinquent bill payments can have a tremendous negative impact on credit and the longer a person pays bills on time, the better the credit score. For example: A person with a credit rating of 707 can raise their score another 20 points by paying all bills on time for a single month. Paying items such as mortgage and rent are especially important. Mortgage lenders like to look at payment trends on mortgage and rent payments.
- Balances need to be low on credit cards. High credit card debt can hurt the credit score and lower the credit score as much as 70 points.
- It is important to not open credit cards that are not needed. New accounts can lower the account age, which can lower the credit score by 10 points.
- It is good to have credit cards, but it is very important to manage them well. Having credit cards and installment loans raise credit scores, especially if payments are consistently made on time. Someone who doesn’t have credit cards tend to be at higher risk than someone who hasn’t managed their cards well.
- Accounts still stick around when they are closed. The account will still show up on the credit report and be factored into the score.
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