You damaged your credit and now you are worried. How will you ever get a loan with bad credit? You know conventional loans are out of reach. But, what about an FHA loan? Will the FHA overlook your low credit score?
The answer is that it depends. Yes, the FHA does allow “lower” credit scores. Just how low they will go depends on several factors, though.
The Minimum FHA Credit Score
The FHA requires a credit score of 580 to qualify for the loan. That’s the FHA, though. Certain lenders may require a higher credit score. It depends on what your other factors look like. For example, if you have a high debt ratio and unstable income, a lender probably won’t accept a 580 score. That’s three risky factors – what are the odds you’ll make your mortgage payments on time? In the eyes of the lender, it’s not very high.
The Exception to the Rule
An unknown fact about the FHA is that they will actually allow scores as low as 500. There’s a catch, though. You will have to put down a large down payment. Anyone with a credit score between 500 and 579 must put down 10% on the home. This takes away from the benefits of the FHA loan, as the largest benefit is the low down payment requirement.
Getting Over Bad Credit
Putting the credit score aside, lenders also look at your credit history. While they focus on the score to determine the size of your down payment, the history matters more.
Let’s say you have a 600 credit score, but you have three late payments in the last 3 months on another debt. This doesn’t look good to the lender. Your score is high enough to qualify for the loan, but your history shows a pattern of irresponsibility.
If you have a blemished credit history, you’ll have to take steps to get over it:
- Bring any late payments current – Try to have all timely payments before the lender pulls your credit. If you have late payments in the past, you will at least show that you were able to get over them. If you have an explanation for the late payments, you’d be in even better shape.
- Take time to recover from a bankruptcy or foreclosure – The FHA loan has specific waiting periods after a BK or foreclosure. Generally, you must wait 2 years. Regardless, you must prove that you picked up the pieces and can handle your financial responsibility now.
- Straighten up your credit – If you have a lot of debt, try to get yourself out of it. Pay your credit cards down or off, if you can. Just don’t close the old accounts. You need the older accounts to help keep your average account age high. The older your accounts, the higher your credit score will go.
Create Compensating Factors
Luckily, lenders don’t focus strictly on your credit score or even your credit history. They look at your entire loan file as one big picture. If you have compensating factors, you may be able to overcome your lower credit score.
A few of the most common compensating factors are:
- Stable employment – The longer you stay at the same job, the less risky you look to a lender. It shows consistency. If you have bad credit, it’s not likely due to losing your job or having issues with your income.
- Low debt ratio – No matter how bad your credit history is, you can still have a low debt ratio. This means you don’t rack up your credit accounts unnecessarily. You also don’t take on debt that you can’t handle. The lower your debt ratio, the less risk you pose.
- Reserves – Lenders look at any assets you have outside of what you use for the down payment as reserves. As the name suggests, it’s money on ‘reserve’ if you can’t make your mortgage payment. It’s like a cash back-up. The more reserves you have, the more stable your loan file.
Now, here’s the real issue. Lenders have overlays. Lenders also have the final say. They must abide by what the FHA says at a minimum. But that doesn’t mean they can’t add their own requirements. Let’s say a lender doesn’t want to take a risk on someone with a 580 credit score. They can set a higher minimum credit score. They can go as high as they want. They are the ones funding the loan.
Lenders also have other overlays. They may set the maximum debt ratio lower than what the FHA allows. They may also require a specific amount of reserves or a minimum amount of time at the same job.
The beauty of lender overlays is you can shop around. Each lender has different requirements. You may find a lender that has less stringent requirements if you apply with a few lenders. One lender may turn you down, but that doesn’t mean another won’t accept your level of risk.
The bottom line is that you can get an FHA loan with bad credit. It just depends on the lender you use. It also depends on how you handle your finances before you apply for the loan. You have to make your financial situation look as attractive as possible. No matter how bad your credit is in the past, you have to show that you overcame that. If you do, your chances of getting a loan approval are much higher.