Key insights
- Loan candidates with low credit scores should understand how their loan interest rate could be impacted by their financial history
- Those with low credit scores may also benefit from securing FHA loans, which are designed to help higher-risk borrowers
- By showing a lender your low credit score is on the rise, you may be a more desirable candidate for a loan than someone whose low score is stagnant
Many of today’s first-time buyers worry about their credit scores. Whether you have student loans you just can’t shake or you’re still plagued by a few missed payments from a college-era utility bill, don’t assume you will be locked out of the market forever due to your FICO score.
Here are insights you can use as you determine if you are eligible for a mortgage despite your low credit score.
Pay higher interest rates
You’ve likely heard that interest rates remain low by historical standards and you may be counting on the low rates you’ve seen quoted online. It’s important to remember that mortgage interest rates vary for each buyer and are closely tied to the risk they represent for the lender.
In other words, those with damaged credit can still qualify for a loan, but they may have to pay a higher interest rate. Borrowers with a credit score of 760 or higher are likely (but not guaranteed) to obtain the lowest mortgage rates available. Meanwhile, those with a lower score could be approved at a higher interest rate. Remember: the higher your loan rate, the more you'll pay over the course of the loan.
Consider FHA loans
Buyers with low credit often opt for a Federal Housing Administration (FHA) loan. FHA loans are designed to act as “helper loans” to those who earn enough to pay a monthly mortgage, but lack the long-term credit history that would prove they are low-risk borrowers.
As a result, FHA loans are often approved for borrowers with lower credit scores and they may require smaller down payments than conventional loans. Buyers with a credit score of 580 or above may be eligible for a home loan with a 3.5 percent down payment; buyers who are approved for a loan despite a credit score below 580 may pay 10 percent down at closing.
Because FHA borrowers are considered to be higher risk, the FHA requires that buyers purchase mortgage insurance at the time of closing; buyers will also pay mortgage insurance monthly over the course of the loan.
Show your credit score is on the mend
While your credit score may seem like a hard-and-fast number that will determine the fate of your approval, the reality is that two people with the same score can appear very differently to lenders.
Consider these two scenarios:
After losing their job during the Great Recession — and making a few late student loan payments as a result — Candidate A has not missed a payment of any kind in 25 months. They have a solid job history and their monthly rental payments to their landlord are comparable to what they would pay in a mortgage payment. As a result of their hard work and on-time payments, Candidate A has a credit score of 625.
Candidate B is forgetful and they have paid two car payments late so far this year. They carry a high balance on their credit card from month to month and tend to pay the required minimum at billing. They have changed jobs three times in the last two years but they pay a monthly rent that is comparable to what they would pay for a mortgage loan. As a result of their high credit card usage and shaky payment history, Candidate B’s credit score has slipped from 700 to 625 in the last year.
As you might imagine, Candidate A would likely be considered a less risky loan prospect than Candidate B — even though they have identical credit scores.
If you have a low credit score, try out a free service that tracks your score and provides insights on why it’s going up or down. You may find that by making easy tweaks and paying your bills on time, you can prove that you are a worthy borrower who is responsible enough to secure a home mortgage loan.
What happens if I'm not approved?
If you aren't approved for a mortgage, it's time to work diligently on increasing your credit score. You can also speak to a mortgage loan officer to determine how you can get on track for approval and formulate a plan to put you on the path to homeownership.
