By LOUIS DENICOLA
You're excited and ready to buy a new home - but there's one problem: You have poor credit.
Mortgage lenders often take a close look at your financial situation and credit when reviewing your application. Having an excellent credit score and a low debt-to-income ratio (DTI) can help you secure the lowest interest rates.
Even if you have bad credit, you might be able to get a mortgage.
However, you should carefully weigh your options if you're not in a rush to make a purchase. Even if you find a lender who's willing to give you a loan, the monthly payments could be so high that it makes more sense to rent while you build your credit and lower your DTI ratio.
Determine how much home you can afford
Knowing how much home you can afford lets you focus your energy on shopping for homes that are in your budget.
Consider starting by figuring out a few basic numbers:
- Your total monthly income before taxes.
- Your total monthly debt payments, such as auto or student loan payments. This total includes payments that are owed to a lender -- not bills such as your cable or utility payments.
- How much you've saved for a down payment. It's important to note that the lower your credit score, the more money you may need to put down.
Nick Demeester, senior manager of housing at GreenPath Financial Wellness, a nonprofit that offers counseling and advice for various financial issues, says it's important not to lose sight of your other financial goals when creating a budget for your home purchases.
"Will you still be able to contribute to retirement goals, are you still able to pay down other debt obligations like student loans or credit cards and are you setting aside funds for an annual vacation you like to take?" Demeester asks.
The first two numbers can help you to determine your DTI ratio. Your DTI ratio is important to know because it's one of the factors lenders use to estimate your ability to repay your loan.
To calculate it, take your monthly debt payments (including your future monthly mortgage payment) and divide it by your monthly pretax income.
DTI requirements vary by lender and your overall financial situation. Having a DTI of 36 percent or lower is a good rule of thumb, but some lenders may approve mortgages for applicants with a higher DTI.
Housing expense-to-income ratio
The ratio of your housing expense-to-income is another important ratio. Take your expected future housing expenses -- including loan payments, taxes, insurance, and required fees or association dues -- and divide by your total pretax income.
The ratio rule of thumb is 28 percent or lower, but again, there are exceptions.
Keep the closing costs in mind when considering your down payment, as they may affect how much you can afford to put down. Closing costs may range from about 2 to 6 percent of the purchase price.
Check your credit
Demeester says credit is a huge factor in determining what interest rate you might qualify for. "We encourage everyone to review a copy of their credit report well in advance of applying for a loan."
You can find free copies of your TransUnion and Equifax credit reports on Credit Karma and you're entitled to one free credit report from all three bureaus once a year at AnnualCreditReport.com.
Look for errors, such as accounts that don't belong to you or misreported late payments. You can file a dispute and if a negative mark gets removed, your score may increase.
There may be a downside to disputing accounts. Matt Weaver, a vice president at Finance of America Mortgage, warns that some mortgage lenders may require the dispute to be finalized or withdrawn before finalizing the mortgage.
If you have legitimate negative marks on your credit report, such as a late payment, consider sending a letter that explains the situation with your application, and ask the loan officer to take it into consideration.
Ask someone to co-sign
If you don't think you'll get approved on your own, one option is to ask someone else with a better financial situation to co-sign the mortgage. This could be your spouse or long-term partner, or a relative.
The lender may examine the co-signer's credit, income, DTI and other qualifications as part of the application process. Erin Lantz, vice president of mortgages at Zillow, recommends discussing the decision and impact with a financial adviser and a mortgage lender.
However, it also creates a serious financial tie between you and the co-signer, as you may both have an equal share in the property. Your relationship could be strained if you run into financial trouble, as your co-signer is legally responsible for the debt.
Shop mortgage lenders
Conventional loans -- those that follow established guidelines and aren't part of a government program -- are often best suited for those with good to excellent credit.
You may be eligible for some non-conforming conventional loans if your credit needs work, but they could have high interest rates, additional fees or extra insurance requirements.
A non-conforming loan doesn't meet bank criteria for funding. Examples of non-conforming loans include jumbo mortgages (where the size of the mortgage exceeds the maximum size of a conforming loan, which is $417,000 in most U.S. counties).
Demeester recommends that you shop around for rates and says, "Talk to different lenders -- at least three -- to see what you qualify for in terms of loan amount and interest rate."
You can look for mortgage offers from banks, credit unions and mortgage companies, and ask friends, family and local real estate agents for recommendations.
You could also hire a mortgage broker to reach out to several lenders for you. However, you may have to pay a fee for the service.
The Consumer Financial Protection Bureau (CFPB) has a tool that allows you to explore interest rates in your area based on your credit score range that will help you get a better understanding of what a competitive rate may look like for your situation.
Consider an FHA-backed mortgage
The Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development (HUD), provides assistance to homebuyers who have credit that needs work or can't afford a large down payment.
You can find a HUD-approved housing counselor near you to walk through all of your options.
The FHA doesn't offer the mortgages directly -- rather it insures mortgages lent out by FHA-approved lenders.
You may be able to get an FHA-insured mortgage with a down payment of 3.5 percent if you have a credit score of at least 580. To get approved with a credit score between 500 and 579, you'll need to put 10 percent down.
There are also other requirements to qualify for an FHA loan and there's a limit to the amount you can borrow based on where you're buying and your down payment.
In addition to the closing costs, you may have to pay an upfront mortgage insurance payment -- although it can be rolled into your mortgage. You'll also have to pay an annual or monthly mortgage insurance premium.
If you don't have a credit score because there isn't sufficient information within your credit reports, you may still be able to get approved for an FHA loan by providing proof of at least three alternative payment histories - these could include your rent, gas, electricity, water, cable or Internet payments.
A low credit score can make getting a mortgage more difficult, but there may be options.
However, before focusing on finding a home, determine your budget and review your credit reports to understand why your credit score is low.
If purchasing a home doesn't make sense for your budget, it may be better to work on increasing your score and lowering your DTI ratio for now and consider purchasing a home when you have a score that can help you get a better deal on a mortgage.
If you've decided that it still makes sense to purchase a home now, consider the benefits and risks of asking someone to co-sign and compare loan options and rates from different mortgage lenders and government programs.
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