You've found the house. You have the savings for a down payment and the cash flow in your budget to afford the payments. Everything is great, except for one thing: Your credit score is bad. Is this a death knell for your home purchase?
Maybe. But then again, maybe not. Here are the best strategies and tactics you can follow to overcome that credit score and buy the house in spite of it.
What is a bad credit score?
Generally speaking, credit scores break down as follows:
There are tons of different reasons a credit score could fall; however, moving into that below average or poor range takes a pretty serious event like several missed payments, bankruptcies, foreclosures, or collection accounts. But don't worry... life happens to even the best people, and a missed payment in the past is not the end of your home buying journey.
A bad credit score simply indicates to a bank that you've had trouble repaying debts in the past. To overcome that history, you must take extra steps to prove to the bank that history won't repeat itself. To do this, you must think like a bank.
How to think like a bank
Banks care first and foremost about getting repaid. That means you must prove to the bank that the loan will be repaid. Remember, as we work through these concepts, you probably won't have every "i" dotted and "t" crossed. That's OK. At the end, we will bring it all together with a solution for the worst-case scenario.
Question 1: How are you going to repay the loan?
Typically, the answer to this question is through your monthly cash flow. This is the income from your job after you subtract your living expenses like food, water, electricity, debt, etc. Banks use a ratio called the debt-to-income ratio to determine if your monthly cash flow is sufficient to afford the debt. The ratio is calculated by dividing your total monthly debt payments into your total monthly income (before taxes).
For borrowers with good credit, a 40%-50% debt-to-income ratio is typically enough to qualify for the loan. For those with credit problems, this ratio needs to be much less.
Question 2: If that doesn't work out, what is the backup plan?
What happens if you lose your job? That could be the reason your credit score isn't the best in the first place. The reality is that this can happen and, when it does, both bank and borrower feel the financial pressure. That's why banks always look for a backup plan.
Do you have any savings or cash hidden under the mattress? Banks will want to see enough savings to cover your living expenses and debt payments for at least six months. The more savings, the better.
It gives the bank comfort that, if something goes wrong, you, your family, and the bank will all be financially stable until you can find another income source.
Question 3: What happens if your backup plan fails?
It may seem like overkill, but banks want a backup plan for the backup plan. When all else fails, the bank wants to make sure that if the house must be sold, the loan will be repaid. Unfortunately, this often means foreclosure.
To you, that means a bigger down payment. By putting in more of your money up front, it creates breathing room for the loan if it must be sold quickly. If a conventional mortgage requires a 20% down payment, try to put down 30%, 40%, or more.
You may be thinking, "Why should my family put in more money now just so the bank won't lose money later?" Well, if you don't do this, you most likely won't get the loan. And if you accept the loan, you're giving your word that you'll repay the debt. As long as you pay the monthly payments as you've agreed to do, you have nothing to worry about.
Putting down a bigger down payment will benefit you by lowering the monthly payment, as well, making it less likely that you'll ever be in the worst-case scenario in the first place. Even further, it gives you more leeway to sell the house yourself prior to foreclosure, saving your credit score from further damage in the future.
Again, the idea with all of these considerations is that, because your credit score is low, you need to prove beyond a shadow of a doubt that you can and will repay the loan.
The worst-case scenario
What if you've worked hard, saved up, dotted your "i's" and crossed your "t's," but the bank still won't approve your loan? You have the cash flow, the savings, and the down payment, but you still get declined for a conventional mortgage?
At this point, it's time to look at subprime options. Subprime is a kind of dirty word in the post-financial crisis world; but that doesn't mean it's not a viable solution for many families.
With a subprime loan, the specialized banks and lenders mitigate the perceived risks of a loan by charging a substantially higher interest rate. They lower their lending standards so that you can get the money you need. The higher interest rate is, in essence, the bank charging more for lowering those standards.
The subprime loan will be much more expensive, but at least you're able to get the financing you need to buy the home. Over time, as your credit score improves, you should be able to refinance that subprime loan into a conventional loan with a better rate.