Let's be honest. Even though FHA loan rules say that applicants with credit scores as low as 500 are eligible for financing, the chances of being approved for a home loan with a low credit score are not terrific. However, there is no reason to despair. The minimum credit score for home loan is improving, with FHA lenders rolling back their minimum FICO score requirements in 2014, and one of the country's largest banks recently dropped its 660 threshold to a more doable 620, and some have gone as low as 600.
FHA Reality Check
FHA allows scores down to 580 for a 96.5 percent loan and 500 for a 90 percent loan -- but almost no one qualifies. According to the FHA's 2013 annual report, applicants with credit scores of 620 or lower face difficulties obtaining a loan through FHA. Primarily, two things are at work:
- FHA loan rules allow lower credit scores, but the FHA does not allow for bad credit. Any major financial problems must be resolved and the recent credit history (last 12 months)needs to be solid. The FHA also considers whether an applicant's credit issues stem from life events beyond his or her control or from a lack of fiscal responsibility.
- While FHA can lower its credit score guidelines, this doesn't mean lenders have to follow suit. Most mortgage companies actually add overlays to FHA guidelines by setting minimum credit scores between 620 and 680. However, that is improving.
In 2013, less then one-fifth of one percent of FHA loans were granted to applicants who had credit scores below 580, and just two percent of FHA loans went to applicants with scores between 580 and 619.
These numbers are from 2013, however, and lenders are easing up. If the trend continues, more people with scores of 620 and under could become eligible for approval in 2015.
When Things Have Gone Seriously Wrong
If applicants have suffered a recent short sale, foreclosure or bankruptcy, they may be ineligible for a traditional mortgage no matter what they do. After a foreclosure or short sale hits a credit report, FHA typically waits at least three years before considering approval of a mortgage. However, there are exceptions. FHA's Credit Underwriting guide says that
The lender may grant an exception to the three-year requirement if the foreclosure was the result of documented extenuating circumstances that were beyond the control of the borrower, such as a serious illness or death of a wage earner, and the borrower has re-established good credit since the foreclosure.
A borrower who faces a situation like foreclosure or bankruptcy can look to other options: private financing (also called hard money), seller financing or even a lease option. With hard money, lenders base their lending decisions on the property and down payment, not the borrower's credit -- they structure the loan so that no money will be lost on their part if the borrower defaults. These loans require high down payments -- 30 percent or more is typical -- and charge several points up front loan rates two-to-four times those of mainstream lenders.
Owner financing can go one of two ways: it is either a lifesaver or a scam. Before choosing this route, borrowers should have the home they are considering inspected and appraised so they know what it's worth and that it's safe. They should also obtain title insurance and have a real estate attorney review their contract before signing. Above all, borrowers need to make sure their payments are affordable.
Borrowers should be just as cautious about lease options as they are about owner financing. One reason for this is that homeowners do not need to offer the same types of consumer protections that licensed lenders do. Borrowers need to look out for themselves.
Where to Begin
The first thing borrowers may need is advice, and most lenders are willing to provide that free of charge. Companies offering less restrictive guidelines can even be found through the LendingTree network. Lender Ratings & Reviews can also help them find a company with which they are comfortable.
The U.S. Department of Housing and Urban Development (HUD), which oversees FHA lending, provides a Web page through which borrowers can search for a local, approved housing counseling agency for home ownership education, down payment assistance and other programs.
One of the best ways to become eligible for a competitive mortgage is to rebuild one's credit. It doesn't have to take years to reform a bad score, and the good news is that recent positive history is weighted much more heavily than older bad history.
- Get current, Blemishes on a credit report do begin to fade with age, but new derogatory information hits hard. Aspiring homeowners should pay everything on time starting now.
- What about collections? If collection items are a few years old, it's generally better to leave them alone. New activity on a derogatory account gives it more weight and that can drop a credit score. Often, collection agencies will remove an account from a credit record (agreements should always be in writing) if the consumer pays what's owed.
- Get a credit report copy. Consumers are legally entitled to a free copy of their report every year from annualcreditreport.com; all they need to do is ask. Once they do have a copy, they should identify problem areas, addressing fixable items as quickly as they can. They can also see their Vantage scores for free on LendingTree's MoneyCenter and track their progress as their score improves.
- Pay down the balance on credit cards. Ideally, a credit card balance should not exceed 30 percent of the credit limit.
- Avoid opening or closing credit cards or other types of accounts. Both of these activities can lower a consumer's FICO score and should be avoided in the months leading up to application for mortgage.
If borrowers follow the above advice, they could become homeowners sooner than they think. On the other hand, some people are great money managers but end up with poor credit due to bad luck, such as unemployment, or another external factor, like ill health. Still others find it hard to stop themselves from overspending. If small debts have previously been problematic, consumers may want to seriously consider whether a new, large home loan is a move they want to undertake.