Many people assume that they can’t buy a home without a perfect credit score, sizable down payment, and a ton of money in the bank. However, that’s actually not the case! Buying a home can be accessible for those with lower credit scores and less cash reserves thanks to federal programs and more flexible requirements from alternative lenders. So before you totally discount buying a home as a result of a poor credit score, learn more about what scores you need and how you can make up for a poor score in other ways.
What Is a Credit Score and Why Does It Matter?
A credit score is a number between 300 and 850 that depicts a person’s creditworthiness to show the likelihood that they will pay their bills on time. Credit scores are an important part of your financial health as they determine your eligibility for loans and credit cards in addition to the interest rates that you will pay on each. Credit scores below 670 are considered fair, between 670 and 740 are considered good, 740 to 799 are considered very good, and 800 and up are considered excellent.
How Is Your Credit Score Determined?
While your credit score may seem like a simple concept since it’s made up of a single number, it’s actually quite complicated since it is determined by several different factors. Many people struggle with understanding credit scores because they don’t know how their score is being calculated. However, knowing what factors influence your credit score can help you take control of your score and take action to improve it.
The most important factor in your credit score is your payment history. Lenders want to make sure that you have made your past payments in a timely manner. This is because lenders see your track record of payments as the strongest predictor of future payment habits.
However, a few late payments won’t necessarily tank your credit score. On the flip side, having no late payments won't necessarily lead to a perfect credit score. Instead, this is one factor that is considered and is weighted so heavily since it’s so easy to track.
Credit card accounts, retail accounts, installment loans, finance company accounts, and mortgage loans all contribute to your payment history. Things like bankruptcies, lawsuits, and wage attachments will negatively affect your score.
2. Amounts Owed (30%)
The second-most important factor in your credit score relates to the amounts you owe to lenders and creditors -- essentially, how much debt you have. Lenders want to make sure that you’re not overborrowing and digging a hole of debt that will be difficult to get out of.
This category considers the amount owed on all accounts, the amount owed on different types of accounts, the number of accounts with balances, the credit utilization ratio on revolving accounts, and how much of the loan amounts are still owed.
3. Length of Credit History (15%)
Your credit score is also based on the length of your credit history. This may seem counterintuitive in a sense. If having a short credit history leads to a bad credit score, how can you possibly qualify for loans and credit cards that you can then use to build up your credit history?
The good news is that you’re not doomed if you’re just starting out since it only makes up 15% of your total score. Your credit history takes into account how long your credit accounts have been open, including the age of your oldest account, the age of your newest account, and the average age of all your accounts. Additionally, it takes into account how long specific accounts have been open and how long it has been since specific accounts have been used.
4. Credit Mix (10%)
Another thing that is used to calculate your credit score is your credit mix. Lenders are looking to see that you can successfully manage different types of accounts. For starters, you may have revolving accounts like credit cards, retail store cards, gas station cards, and home equity lines of credit. You may also have installment accounts like mortgage loans, auto loans, and student loans.
5. New Credit (10%)
The final thing that is used to calculate your credit score is your amount of new credit. This makes up 10% of the calculation. Opening multiple different accounts within a short amount of time is a red flag for lenders. As a result, you want to be careful about how often you open new accounts. Your score considers new inquiries within the last 12 minutes but these inquiries remain on your credit report for two years.
What Credit Score Do You Need to Buy a Home?
The credit score that you need to buy a home depends on what type of mortgage loan you’re applying for. Additionally, different lenders may have different credit score requirements. Here’s a quick guide to the scores you need to buy a home using a conventional mortgage loan, an FHA mortgage loan, and a VA mortgage loan.
Conventional Mortgage Loans
Conventional mortgage loans are not backed by the federal government and are fully owned and operated by private lenders. As a result, lenders are able to set their own minimum credit scores. However, most lenders will want to see a credit score of at least 620 in order to apply for a conventional loan.
That being said, a credit score of 620 may not guarantee a successful application. Instead, you should aim for a higher credit score above 700 for the best chances of approval and a competitive interest rate.
FHA Mortgage Loans
FHA mortgage loans are guaranteed and backed by the Federal Housing Administration in case of default. This decreases the risk taken on by the lender and makes it easier for those with lower credit scores, down payments, and incomes to buy a home.
Again, since FHA loans aren’t given out by the federal government directly, lenders still have control over the qualifications. But since these loans are designed to be more accessible and achievable for lower-income borrowers, lenders generally accept credit scores above 580 for FHA loans.
VA Mortgage Loans
Similar to FHA loans but with a twist, VA mortgage loans are guaranteed and backed by the Department of Veterans Affairs in case of default. These loans are available to service members, veterans, and eligible surviving spouses.
The federal government helps mitigate the risk taken on by lenders offering VA loans so that they can offer less strict requirements. Many lenders offer VA loans to those with credit scores above 640.
Other Factors Lenders Consider When Applying for a Mortgage
Although credit score is an important factor when it comes to buying a home, it’s not the only factor. Lenders also consider factors like debt-to-income ratio, employment history, income, down payment amount, and liquidity when considering your mortgage application.
1. Debt-to-Income Ratio (DTI)
One factor that lenders consider when processing your loan application is your debt-to-income ratio. Also known as DTI, this is a calculation of how much debt you have compared to how much gross income you’re bringing in. Lenders look for low DTI ratios as an indication that you’re not in too much debt and you’re good at managing your money.
Although specific DTI requirements vary by lender, you should aim for a DTI below 36%. The lower your DTI, the better your chances of approval and the lower your interest rate will be. For this reason, it’s a good idea to pay off as many debts as possible before applying for a mortgage loan.
2. Employment History
Another factor that lenders consider when processing your loan application is your employment history. They want to see that you’re able to hold down a steady job. Many lenders want to see that you’ve worked at the same job for at least two years as it shows them that you’re less likely to lose that job and, therefore, your main source of income.
It should come as no surprise that lenders consider your income when processing your loan application. They want to make sure that you can actually afford your mortgage payments based on how much money you make. The good news is that lenders consider your gross income rather than your net income.
The amount you make determines how much money you can borrow for a home purchase. This goes into the debt-to-income ratio that was previously discussed. To get an idea of what you can afford to buy based on your income, take your gross monthly income and multiply it by 28%.
Housing-related costs should take up no more than 28% of your gross monthly income and all debts including car payments, credit card payments, and student loan payments should take up no more than 36% of your gross monthly income.
4. Down Payment Amount
Yet another factor that lenders consider when processing your loan application is your down payment amount. A higher down payment shows lenders that you’re committed to the home since you’re literally more invested in it. Most lenders like to see a down payment of 20% of the purchase value but some lenders will accept down payments as low as 3.5%.
The last factor that lenders consider when processing your loan application is your liquidity. Lenders want to see that you have enough money in the bank to cover your mortgage payments in case of an emergency like a job loss, medical issues, etc. Generally speaking, you should have enough saved to cover at least two months of mortgage payments. However, the more you have saved, the less risky you are to the lender and the lower your interest rate will be as a result.
How to Improve Your Credit Score?
If you don’t have an ideal credit score right now, there are things you can do to improve your credit score to boost your likelihood of approval.
Check your credit report: You should keep a close eye on your credit report for any discrepancies or mistakes that could affect your score.
Make your payments: This one is obvious, but you should make all of your payments on time to improve your credit score.
Pay off debts: Use any extra money to pay down your debts to lower your credit utilization rate and improve your score as a result.
Limit your inquiries: Too many inquiries in a short period of time can negatively impact your credit score. You should especially limit hard inquiries for things like credit card applications, auto loan applications, and mortgage applications as these stay on your credit report for up to two years.
Get credit for your payments: Using things like Experian Boost or UltraFICO to add additional accounts to your credit report like utility accounts, bank accounts, and even rent payments.
Work With Vaster Capital to Buy a Home
As you can see, you don’t necessarily need a perfect credit score to buy a house. However, it may be more challenging for you to find a mortgage solution that works for your credit score and credit history. Traditional lenders like big banks often have strict requirements and little flexibility.
It is beneficial to work with a mortgage broker or lender early in the process so they can assess your current borrower profile and create a plan to help you qualify for the best mortgage possible. Mortgage brokers from companies like Vaster Capital are able to find the best loan products that meet your needs and qualifications.