How to buy a home with a low credit score

Buying a home with a low credit score isn't impossible. Several mortgage options are designed to help people with poor or fair credit become homeowners.

While taking advantage of these programs can help you buy a house sooner, you’ll often have to pay a higher interest rate and more fees. In some cases, you may also need to provide a larger down payment.

• 5 types of home loans by credit score
• Key considerations of homebuying with low credit
• Pros, cons of buying with less than ideal credit
• How to improve your credit before buying a home

5 types of home loans for low-credit borrowers

Several different types of loans are available if your credit score is below average, meaning a FICO score between 580 and 669. Make sure to check the eligibility requirements of each one to find the best fit for your unique financial situation.

1. Conventional loan

Minimum credit score: 620 to 660

Two types of conventional mortgages help people become homeowners regardless of credit score or income:

• HomeReady from FannieMae: With a low 3% minimum down payment, the HomeReady mortgage is for lower-income homebuyers. The minimum credit score requirement is 620.
• Home Possible loans from Freddie Mac: This is a similar loan program with the same down payment minimum of just 3%. However, Home Possible loans come with a slightly higher credit score requirement of 660. Eligible borrowers must meet income limits for their area.

Keep in mind that you'll have to pay your lender private mortgage insurance (PMI) if your down payment is less than 20% of the home’s purchase price.

2. FHA loan

Minimum credit score: 500 to 580

An FHA loan is a type of private mortgage that’s guaranteed by the Federal Housing Administration. It has one of the lowest credit score requirements. You can qualify for a 3.5% down payment on the home purchase price if your credit score is at least 580.

It's still possible to qualify with a credit score as low as 500, but you'll need to provide at least a 10% down payment. FHA loans require an upfront and ongoing mortgage insurance premium, which adds to the cost of this low-credit home loan.

Keep in mind that all FHA loans require both an upfront and annual mortgage insurance premium (MIP) of 1.75% regardless of the amount of down payment you provide.

3. VA loan

Minimum credit score: Varies by lender

A VA loan is a government-backed loan that’s specifically intended for veterans, service members and eligible surviving spouses. One of the unique features of a VA loan is that there’s no down payment required and it comes with flexible credit requirements. In fact, there’s no minimum credit score requirement to qualify for a VA loan.

Unlike other low-down payment loan options, there's no private mortgage insurance required. While private lenders administer VA loans, you'll need to get a Certificate of Eligibility that shows you or your spouse have met the service requirements for eligibility.

For VA loans, you’ll pay a funding fee in addition to closing costs. The amount you’ll pay depends on your loan amount, down payment and the type of loan you borrow. This fee is a one-time payment that offsets the need for down payments and mortgage insurance.

4. USDA loan

Minimum credit score: 640

The Department of Agriculture offers zero-down payment home loans for buyers seeking to purchase in a rural area. The minimum credit score requirement is just 640. There are, however, a few restrictive eligibility requirements.

First, there are income limits based on geographic location and family size. The home you're buying must be in a designated rural area. You can use the USDA's address look-up tool to see what areas near you qualify.

5. Non-qualified mortgage

Minimum credit score: Varies by lender

Qualified mortgage loans have specific legal guidelines to discourage risky borrowing, such as strict debt-to-income (DTI) requirements and loan terms capped at 30 years. These types of loans use traditional means of income verification — such as tax returns, pay stubs and W-2s — to evaluate your eligibility for a loan.

A non-qualified mortgage is any loan that doesn’t meet all of the criteria of a qualified mortgage. These loans can be a good fit for borrowers who are self-employed or have fluctuating monthly incomes, as they use alternative methods of income verification when approving your loan, such as reviewing your bank statements rather than W-2s or pay stubs.

These types of mortgages are intended to help borrowers who are unable to lock in a traditional mortgage due to their employment, income or credit score. This means you may be able to qualify for a non-traditional mortgage even if you’ve experienced an event that might be dragging down your credit, such as foreclosure or bankruptcy. Additionally, you can qualify for a non-traditional mortgage even if your DTI ratio is above the standard 43% threshold.

Key considerations of home buying with low credit

Your credit score isn't the only factor mortgage lenders consider when evaluating your loan application. Here are several factors lenders consider when determining if you qualify for a mortgage:

• Debt-to-income (DTI) ratio: This compares the amount of your monthly income that goes toward debt payments, displayed as a percentage. Lenders will consider this number to determine if you can afford a monthly mortgage payment. To find your DTI, add up all of your monthly debt payments (including your new mortgage, car payments, student loans and credit card minimums). Then divide that number by your gross monthly income and multiply by 100 to get a percentage. Most lenders require a DTI under 50%, but this number can vary depending on what type of loan you borrow.
• Loan-to-value (LTV) ratio: LTV refers to the loan amount compared to the value (or purchase price) of your new home. A lower LTV indicates a larger down payment. So, if you purchase a $300,000 house and make a $30,000 down payment (10%), then your LTV ratio is 90%. This number also determines if you’ll have to get private mortgage insurance.

The following terms don’t affect your eligibility but are important to know when shopping around for a mortgage:

• Interest rate: The interest rate can either be a fixed rate that never changes, or an adjustable rate that fluctuates depending on the real estate market.It's important to note that mortgage interest is amortized. This means that even though your monthly payment stays the same each month (unless your rate adjusts), the amount that goes towards your principal versus interest changes over time. When you first start paying off your mortgage, the majority of your payment goes toward interest, then shifts to primarily principal payments over time. This ensures the lender still makes a profit even if you sell the home shortly after buying it.
• Mortgage insurance: When your LTV is over 80% (or your down payment is less than 20%), you'll typically need to pay private mortgage insurance. This fee is typically added to your monthly mortgage payment. PMI is only required for conventional loans and generally costs 0.10% to 2.00% of your loan amount per year.PMI is usually automatically canceled once you’ve earned 22% equity in your home, but you can request to stop paying it after you’ve reached 20% equity.

Pros of buying with low credit

Here are the advantages of purchasing a home with a low credit score:

• Opportunity to build your credit. Getting a mortgage will add to your credit mix, which accounts for 10% of your credit score. Lenders like to see that you can manage a diverse range of credit, so adding a home loan to your financial profile can boost your score.
• Multiple mortgage programs to choose from. Even if your credit score is less than ideal, a range of loan options are available to you. Depending on your income, geographic location and employment history, you’ll likely be able to find a mortgage that suits your unique needs.
• Potential to refinance to a lower interest rate. If you’ve improved your credit score or interest rates have fallen since you bought your home, you may be able to refinance your mortgage and get a lower rate than you’re currently paying. A lower interest rate can reduce your monthly payments and save you thousands of dollars over the life of your loan.
• Build home equity. Equity is the difference between the value of your home and how much you still owe on your mortgage. You can tap into your home equity with a home equity loan or home equity line of credit (HELOC) and use the funds for virtually any purpose.

Cons of buying with low credit

There are, of course, some disadvantages to consider as well when buying a home with a lower credit score.

• A potentially higher interest rate. Lenders assess your credit score to determine the risk of lending to you. Your credit score determines not only if your loan application will get approved, but also what interest rate you’ll qualify for. With a lower credit score, lenders will likely offer you a higher interest rate to offset the risk that you’ll default on the loan. A higher interest rate will add to your overall loan costs.
• More expensive lender fees. While FHA, USDA and VA loans are worthy options for homebuyers with low credit scores, these types of mortgages often come with additional fees. For example, FHA loans require an upfront and annual mortgage insurance premium (MIP) of 1.75%. VA loans require funding fees that are determined by your borrowing amount and down payment, and USDA loans require buyers to pay an upfront guarantee fee of up to 3.50% of your loan amount.
• May need a larger down payment. While you can still get a mortgage with bad credit, you’ll likely need a bigger down payment than a borrower with good credit. Providing a larger down payment can demonstrate to lenders that you have your finances in order. Additionally, putting down more money upfront can help you lock in a lower interest rate and avoid having to get PMI.

How to improve your credit before buying a home

If your homebuying timeline allows, you may want to take the time to build your credit before submitting a loan application. Here are a few ways to improve your credit:

• Review your credit report. First, get a free copy of your credit report from AnnualCreditReport.com and check for errors. If you see any misinformation, such as incorrect late payments or charge-offs, file a dispute with the credit reporting agency to potentially boost your score.
• Pay bills on time. Payment history accounts for 35% of your credit score, so making all of your monthly payments on time is a quick and easy way to improve your score. Consider enrolling in autopay to ensure all of your bills get paid by their due date.
• Reduce your credit utilization. Your credit utilization ratio is the amount of credit you’re using divided by your credit limit, expressed as a percentage. For example, if you have a $2,500 balance on a credit card with a $10,000 limit, your credit utilization ratio is 25%. You can improve your credit utilization ratio by asking your card issuer to increase your credit limit, or by using your credit card less. Lenders typically like to see a credit utilization ratio no higher than 30%.