A Guide to Getting a Mortgage with Bad Credit

Getting a mortgage with bad credit is possible.

However, you need to know exactly what you’re getting into when you start shopping around for a mortgage. Borrowers with credit scores below a certain point aren’t going to have the same advantages and luxuries that someone with scores in the 700’s would have.

While this doesn’t sound fair, there are good reasons that lenders change the rules for people with bad credit. Understanding what goes into that decision will equip you to leverage your situation in a way that can help you find the best mortgage for your bad credit.

To help you make sense of the process, we reached out to multiple real estate agents and mortgage brokers to get true insider advice and insight.

In this guide, we’ll mix their wisdom with our research to provide you a step-by-step tutorial on what lenders consider “bad credit,” how bad credit affects your mortgage, which types of mortgages you can get as well as the advantages of using a mortgage broker over a bank for your situation.

Finally, we’ll include a quick section on how to raise your credit score in 12 months or less, something that could save you tens of thousands of dollars over the life of your mortgage.

Before we get started, though, it will help you to know that when we talk about your credit score, we’re referring to the score that lenders use to determine your eligibility for a mortgage.

This score, according to Linda Suazo, president and senior loan originator at Mortgages by Linda in Jacksonville, FL, is known as a “tri-merge.” It’s the middle score among your Experian, TransUnion and Equifax scores. So, if those three scores are 590, 600 and 605, respectively, then the score lenders look at is 600.

What Is Bad Credit? Understanding How Mortgage Lenders Think

Bad credit has different meanings for different lenders. When it comes to mortgages, most experts agree that “bad” means a score below 640.

But it’s not just the score that lenders take into account, Suazo said. They’ll also look at the reasons why your score is so low.

Suazo pointed out that someone who has a 600 because of a bankruptcy, foreclosure or short sale a few years ago but has sparkling credit since could be viewed as a more reliable borrower than someone who has multiple 30-day-late marks on their report over the past few months.

A bankruptcy seems much more severe than paying your bill 31 days late. However, a lender, and, more specifically, their number-crunching underwriting department, sees a huge difference.

In the first scenario, the borrower made a mistake but has worked hard to make on-time payments, keep their debt low and rehab their credit.

If you’re in the category of a borrower who has late payments in the past 12 months on their credit report, there’s a good chance you’ll be rejected for a mortgage or have a really hard time getting one.

The reason behind this isn’t so much that lenders are intent on making life hard for you. Rather, most lenders end up selling their mortgages to two government agencies known as Freddie Mac and Fannie Mae. These two companies have specific standards for the mortgages they buy.

When you apply for your mortgage, the lender will run your application through underwriting software that’s based on Freddie Mac and Fannie Mae standards. Your bad credit scores will get one of three results: approved, denied or a “refer.”

Suazo said that you’ll get an automatic denial if you have a payment that’s more than 30 days late in the past 12 months.

Approvals mean that you’ve passed the test even though you have bad credit scores.

The third option is a “refer,” which means the lender has the option of doing manual underwriting. This means that an actual person – not software – will work with you to determine if you should get a mortgage.

In situations like this, Suazo said you may be asked to write a letter explaining what happened to make your scores so low and what you’ve done since the incident(s) to ensure they don’t happen again.

A good example, she said, is someone who ran into financial trouble and ended up making several late payments on their auto loan. Since those late payments, you’ve acquired a secure job and set up autopay to make sure you never pay late.

These are the type of things you can do to sway the underwriter’s opinion into your favor, she said. Keep in mind though, that writing a letter explaining the circumstances behind your score doesn’t guarantee an approval.

For you, the most important thing you can take away from this is that it’s vitally important to change your financial habits after your score goes down. Underwriters want to see proof that you’ve learned from your mistakes.

Pro tip: Fannie Mae, Freddie Mac, and the FHA may prohibit you from getting a mortgage for 2-7 years if you have a bankruptcy, foreclosure or short sale in your credit history.

How Do Bad Credit Scores Affect Your Mortgage?

Mortgages lenders see bad credit scores as a sign that you are a risk when it comes to managing your money. The last thing they want to do is give a mortgage to someone with bad credit who ends up not being able to make payments.

“You have to prove your creditworthiness if you want to make the largest financial transaction of your life. You have to prove you can manage that payment well,” Suazo said. “If your credit score is low, you are more of a risk to the lender.”

And because of that risk, the lender is going to want to make sure they minimize the chances that they’ll lose money.

So, Suazo said, a person with a 580 credit score could have an interest rate as much as 1% higher than someone with a score of 780.

A 1% difference on a $250,000 mortgage is $100 a month and $36,000 over the life of a 30-year loan.

» For Further Reading: How a Good Credit Score Can Save You Money on Mortgage

Several of the experts with whom we spoke told us that lenders may require you to pay points up front. “Points” refers to percentage points of the mortgage amount that you pay up front.

Additional factors, Fit Small Business real estate investment writer Allison Bethell said, include having cash reserves on hand.

“They may get a higher interest rate and be charged something called points which are lenders fees. Each point equals 1% of the loan,” Bethell said. “Other qualifications like cash reserves may be required and the lender will check their income and employment history.”

In general, said Randall Yates, CEO of The Lenders Network, your bad credit will inevitably lead you to pay more than someone with good credit.

“If you have poor credit you’re going to pay for it when you get a loan. Not only can you expect a higher interest rate, closing costs can be as high as 4-6% of the loan amount,” he said.

And, keep in mind that every lender is different because they each have different standards for lending. They will calibrate their rates and closing costs based on your unique situation. There are no guarantees that a certain credit score will get a certain type of mortgage.

The Types of Mortgages You Can Get with Bad Credit

If you’ve got bad credit, you have two main options for getting a mortgage: FHA and VA loans.

FHA Loans

Many of our experts pointed to FHA loans as the ideal loan for someone with bad credit. Their reasoning? The FHA, which stands for Federal Housing Administration, is willing to back loans for consumers with scores as low as 580 and, in some cases, 550.

This is vastly different than banks like Chase, Bank of America and Wells Fargo, Suazo said, who often require credit scores of at least 640 because they’re the ones who are giving you the money for the loan. They want to minimize their risk, so they weed out low scores with high standards.

Now, there’s a specific reason why we mentioned that FHA loans are available to people with credit scores of 580 and 550. At 580, you can make a down payment of 3.5%, Suazo said. If you’ve got a 550, all hope isn’t lost because you’re still eligible – if you can make a 10% down payment.

Take a moment to consider that. Is your tri-merge score 550? If so, you might have to be willing make a substantial down payment in order to get your loan.

On a $250,000 loan, a 3.5% down payment would be $8,750 and a 10% down payment would be $25,000; that’s a huge difference.

As someone with bad credit, it would benefit you greatly to get your scores up to at least 580 so you can avoid having to make a 10% down payment on an FHA loan.

VA Loans

VA loans are also an option if you have bad credit, Suazo said. According to the federal help page for VA loans, there is “no minimum credit score requirement”. Rather, the VA “requires a lender to review the entire loan profile to make a lending decision.”

In other words, the VA (Department of Veteran Affairs), says that lenders have to look at your whole financial situation and not just your credit score.

This is a great requirement if you’re someone who had some serious financial mistakes in your past that destroyed your credit but have spent the past year (at least) building a flawless credit history.

The main drawback to this loan is that it’s only available to retired and active duty members of the military, as well as reservists, members of the National Guard and spouses of deceased veterans (in some cases). Each one of these types of borrowers has to meet requirements for minimum time served.

A Quick Word About Other Loan Options

FHA and VA loans aren’t the only mortgages that are available to those with bad credit scores. Private companies who aren’t associated with banks may offer loans to borrowers with low scores. However, they have their own unique criteria for approving you.

And, more importantly, they often use investment money to fund your loans as opposed to selling your loans to Fannie Mae and Freddie Mac. This means they’re taking on the long-term risk of the loan.

Evan Roberts, a real estate agent with Dependable Homebuyers in Baltimore, told us these lenders can be an option for bad credit borrowers.

“Off-market lenders are often small, local company that lends using private funds rather than money from the federal bank,” Roberts said. “Examples in the Baltimore/Washington DC area are Metro Mortgage, Relationship Lending LLC, Washington Capital Partners, and Zippy Loan.”

Keep in mind, though, that these lenders may charge you higher interest rates than what you’d get with an FHA or VA loan.

Mortgage Brokers vs. Banks for Bad Credit Mortgages

As someone who has bad credit scores, your options for mortgages are limited. To find success, you’ll need to cast a wide net and get quotes from multiple lenders who are willing to take you on as a customer.

Banks, as we mentioned earlier, tend to have stricter criteria and usually require that you have credit scores of 640 or above. And, they’re offering loans from one lender: themselves.

Knowing that, we believe, based on our research and interaction with experts, that mortgage brokers are a good resource for you. These brokers work with multiple lenders and can keep your options far more open than a bank lender.

“A mortgage broker like myself are wholesale brokers and we are affiliated with several different lenders. Their guidelines aren’t as strict as if you go to a Chase, Bank of America or Wells Fargo because they are stricter with credit scores,” Suazo said. “Banks will require high credit scores with low debt-to-income. A wholesale broker like myself can find loans that accept a lower credit score and higher debt-to-income ratio.”

How to Raise Your Scores to Get a Better Mortgage

What happens in the 12 months before you get your credit history checked for a mortgage is, according to the experts, a crucial part of whether or not you can get a mortgage with bad credit.

Based on our research, the three most effective ways you can increase your credit scores in less than a year is to make on-time payments, pay your credit cards down below 30% of their credit limits and remove any inaccurate negative information on your credit report.

Your payment history is the most important factor in your credit scores. How much of your credit limit you’re using is the second most important factor, which is why we recommend getting your credit card balances under 30% of your credit limit.

And, finally, errors on your credit report could be dragging down your score. Using free credit score websites are good resources for checking your credit history and identifying and reporting errors.

Final Thoughts

Having bad credit scores doesn’t disqualify you from getting a mortgage but it will result in you paying higher interest rates and, in some cases, a higher down payment.

As our experts have pointed out, FHA home loans are your best bet for getting a mortgage when your credit scores are low.

If you qualify for VA loans based on your military service, then you’ll find some possibilities there, too.

And, while private lenders may be more willing to give you a mortgage, there’s a good chance you can expect interest rates that are higher than what you’d get from a traditional lender.

The main thing you need to know is that you have options. Get mortgage quotes from multiple lenders, but make sure you talk about your situation to see if your credit profile is a good fit for the lender’s standards.

Our experts suggest using a mortgage broker because they can provide you with more options for bad credit than your bank will.

If you have bad credit and you want to prepare yourself for a mortgage, we suggest raising your score as much as you can before applying for a mortgage. Show the lender you’re a responsible borrower. Pay your bills on time. Keep your credit card balances low.

If you want to learn more about raising your credit, take a moment to read through our guide on how to raise your credit score fast. We provide sound, well-researched advice that will help you boost your scores without cutting corners.

J.R. Duren

J.R. Duren is a personal finance reporter who examines credit cards, credit scores, and various bank products. J.R. is a three-time winner at the Florida Press Club’s Excellence in Journalism contest. He is a member of the Society of Professional Journalists and his insight has been featured on Investopedia, GOBankingRates, H&R Block and Huffington Post.

A Guide to Getting a Mortgage with Bad Credit