You have bad credit. You also want to become a homeowner. How do you overcome your credit obstacles, to realize that goal?
Right now, you’re now renting an apartment or house. Perhaps, you’re living with relatives, until you get your credit and finances back in order.
It might seem like it is impossible to get from being a renter with poor credit, to a homeowner with decent to good credit. It might seem even crazier if we told you this could be done in just 12 months. I assure you, we’re not joking.
There’s a clear road from poor credit to homeownership. It involves two closely related but separate activities: Building credit and repairing credit.
In this piece, we’ll review the exact steps you need to take to build and repair your credit, so that you can purchase a home in the next year. Before that, we’ll cover the various mortgage products that exist, and what credit score you’ll need to qualify for each one. Let’s dive in.
Mortgages & Credit Scores
First, it’s important to understand a bit about how credit scoring works, specifically for mortgages. Specifically, we’ll want to focus on your FICO score. There are many different versions of FICO scores.
FICO versions 2, 4, and 5 are used for mortgage decisions. FICO Version 5 is associated with your Equifax credit report. FICO Version 2 is for your Experian report, while FICO Version 4 is associated with the TransUnion credit report.
When you apply for a mortgage, lenders will typically use the middle of your 3 scores, to decide whether you qualify for a loan. Let’s say that your FICO Version 5 score is a 660, while your FICO Version 4 is a 640, and FICO Version 2 is a 635. The middle of these 3 scores is Version 2, with a 640 score.
If the lender wants a 640 FICO to offer you the loan, then you’re all set. However, if they’re asking for a 650 FICO, you would not qualify. Even though your FICO 5 score is a 660, your middle score falls below 650. The middle score is what matters.
If you’re applying with a joint borrower (say your spouse), the lower of your two middle scores is what lenders will use. So, if your middle score is a 650,and your spouse’s is a 640, the 640 score is what will matter for the loan.
FICO scores aren’t just relevant for deciding whether you qualify for a loan. They also determine the interest rate you’ll be offered.
In the example above, you qualified for a mortgage with a 640 FICO score. However, you probably weren’t offered the best interest rate.
If your middle FICO score were 680, your rate would have been even better. For the very best interest rates, you typically need a middle mortgage FICO score above 740. With some lenders, you need to be over 760.
What about at the lower end? What sort of scores do you need to get in the door, to qualify for a mortgage?
Well, that depends on the sort of loan you’re looking for, and the lender you’re working with. It’s useful to understand the various types of mortgage loans out there. You can then decide which one makes the most sense for your needs.
FHA Loans
FHA loans are one of the more popular mortgage products out there. FHA loans are insured by the Federal Housing Administration (FHA), which is part of the Department of Housing and Urban Development.
While they’re government insured, FHA loans are issued by private lenders, just like every other type of mortgage. FHA loans typically come with a cap on how much you can borrow. This limit is determined by the county where you reside.
The FHA program allows you to place a down payment of as little as 3.5% of the home’s purchase price. To qualify, you need a middle FICO mortgage score of at least 580.
If your middle FICO mortgage score falls below 580, you might still qualify. However, you’ll need to place a 10% down payment.
Regardless of how much money you put down, FHA loans require you to carry mortgage insurance. This insurance premium is based on how much you’re borrowing, and how long the term of the loan is.
Keep in mind that while the minimum score required is 580, many lenders do not accept borrowers with such low scores. Even though FHA loans are insured by the government, lenders want to avoid default issues. Therefore, many mortgage companies will ask for a score of at least 620 to 640.
Conventional Loans
Conventional loans tend to require higher credit scores than FHA loans. They also permit you to borrow larger amounts, and sometimes to provide smaller down payments. If you’re providing a down payment under 20%, you’ll need private mortgage insurance.
Conventional loans typically require a FICO mortgage score of at least 620. Of course, the higher your credit score, the lower the interest rate you’ll pay.
You should also keep in mind that while conventional loans allow you to borrow a larger amount than an FHA loan, there are two types of conventional loans: Conforming and non-conforming loans.
Conforming loans fall under a certain size, and thus can be funded by government-sponsored entities Fannie Mae and Freddie Mac. Because these loans are smaller, and more easily sold to investors, the rates and terms they offer tend to be better for most borrowers.
In 2021, in most parts of the United States, the conforming loan limit is just over $548,000. In some higher cost locations, the number is considerably higher.
Jumbo Loans
Non-conforming conventional loans are known as jumbo loans. Jumbo loans often require FICO mortgage scores over 700, though some lenders will go a bit lower. Jumbo loans typically are for the most qualified borrowers, as you’ll need to document considerable income, and show cash / assets.
Interest rates on jumbo loans can be higher than for FHA or conforming loans. Why? Well, keep in mind that most mortgages are sold to private investors (usually big investment firms).
These firms tend to purchase non-jumbo loans more easily. Thus, there is a bit greater risk for lenders, in issuing jumbo loans. They compensate for this by charging higher interest.
VA Loans
The US Department of Veterans Affairs (known as the VA) backs loans to members of the military, or those who were honorably discharged. VA Loans are offered by private lenders who are approved by the VA.
VA loans often allow for little to no down payment. Despite the smaller down payment, you might also avoid having to purchase mortgage insurance. VA loans typically tend to offer better interest rates and other terms than conventional loans. In some case, closing costs are also covered by the lender.
Clearly, VA loans offer very favorable terms. This is designed to reward and support those who have served our nation.
Which Loan Is Right For You?
Clearly, there are a number of different loan products you can make use of. Which one makes the most sense for you, is a question that only you can answer. How expensive of a home you want to purchase, your overall finances, and your credit score are all important factors.
While it’s true that you might qualify for an FHA loan with a score as low as 580, there are very few lenders who will work with such a low score. The same is true with VA loans. With conventional loans, you’ll usually qualify at a 620 middle score. Yet, do you really want to be on the borderline?
Our advice is to get your middle FICO score up to at least 640, before you start shopping for a mortgage. This way, you’re not on the borderline, or facing any nasty surprises when you finish up the process.
While credit scores can be quite confusing, there’s a path forward. By implementing the strategies detailed below, you have a good chance of getting your score up in 12 months.
Building & Repairing Your Credit
You might have heard about credit repair, but aren’t sure how it really works. Credit repair is the process of building better credit, removing negative items from your credit reports, and ultimately improving your FICO score.
Let’s look at a few of the most powerful credit repair strategies. If you implement as many of these as possible, you’ll greatly increase your chances of qualifying for a mortgage within 12 months.
Opening A Secured Credit Card
If you have poor credit, and want to build credit, you face a challenge. It’s difficult to qualify for credit cards, if your credit is poor. Yet, it’s tough to improve your credit score, if you cannot open new credit accounts. What should you do?
Secured credit cards are a potential solution. With a secured card, you’ll provide the credit card issuer with a deposit. This deposit equals part or all of your spending limit.
By doing this, you’ve eliminated at least part of the credit card company’s concern. If you don’t pay what you owe on the card, they can take your deposit, and apply it towards that amount.
For this reason, it’s much easier to obtain approval for secured credit cards -even if your credit score isn’t great. How should you use your secured credit card?
We would suggest using the card no more than once per month, and paying the card off in full. Ideally, the purchase you make should be no more than 10% of your card’s limit. So, if you have a secured card with a $200 limit, you should spend no more than $20. Perhaps you buy yourself lunch at Chipotle each month.
Also, make sure that you pay off the balance on your card in full. If you spent $20, pay off the $20 by the card’s due date. By doing so, you’ll build a strong payment history, and avoid paying interest.
Which secured cards make sense for you? If you have direct deposit through your employer, we really like Chime Credit Builder Visa Secured Card.
If you don’t have direct deposit (or are self-employed), then you should think about where your FICO score is today. If your score is weak, but above a 580 or so, then you might consider a secured card with Discover or Capital One.
While approval isn’t guaranteed, your chances are decent. These cards also offer upgrade options (to unsecured cards, with higher limits) if you always pay on time.
If your FICO score falls below 580, we suggest either OpenSky from Visa, or Credit Builder Card. These cards typically have little to no credit requirements.
Being Added As An Authorized User To A Credit Card
It is important to have your own credit cards. With that said, you can certainly benefit from someone else’s good credit.
How? Have them add you as an authorized user to their card. As an authorized user, their credit card account will appear on your credit reports, and thus boost your credit score.
To become an authorized user, all the cardholder (the person whom the card was issued to) has to do is call the car issuer, and ask to have you added as a user. Within 60 days, this account should appear on your credit reports.
It’s important that you’re careful in deciding who you want to add you as an authorized user. You want to choose someone who always pays their cards on time, and keeps their credit card balances low.
Ideally, they should be spending no more than 30% of their limit on the card. Even better is below 10%. Also, this person should have had the card open for at least a few years
Where might you find someone to add you as an authorized user to a card? The best approach is to speak with a friend or relative whom you consider responsible. See if they can add you to their card.
They don’t have to actually give you access to the card. Thus, there is no risk to your friends or relatives. Simply adding you to the card will benefit you.
Open A Credit Builder Account
One of the more exciting financial products to come out in recent years is the credit builder installment account. This financial product involves a risk-free loan, which you repay to build credit.
Typically, the credit builder loan provider will set aside some amount of money, in a savings account. This money will be held in your name, but you won’t have access to it.
You’ll make payments towards what was set aside. In monthly installments. At the end of the loan term, you’ll get back the money that you paid, minus some interest charges and fees.
Let’s use a very concrete example. The credit builder loan provider sets aside $600 for you, in a savings account. You don’t have access to this money. You then repay the $600, for 24 months, at $25 per month. Each of these payments is reported to the 3 major credit reporting agencies.
At the end of 24 months, you’ll get back the $600 you paid, minus some interest and fees. In total, they’ll return about $525. Having a loan reported to the credit reporting agencies for 24 months, will greatly benefit your FICO score.
Self Inc is perhaps the best known provider of credit builder accounts. Their pricing structure is what we shared above. One of the things we really like about Self Inc is that if you have an installment account for several months, they’ll offer you a secured credit card from Visa.
You don’t have to put up any additional deposit to obtain this card. Of course, it benefits your FICO score. Opening a Self Inc account allows you to achieve two goals at once.
Credit Strong is another excellent credit builder product. Credit Strong is a bit more affordable than Self Inc. They offer a plan with $15 monthly payments, for up to 8 years of payments. Having a long-term loan further benefits your FICO score, as the account ages.
Having Collections Accounts Deleted In Exchange For Payment
If you have any unpaid medical, credit card, apartment, utility, cell phone, cable gym (or other) bills, you might have collections accounts. When a debt is unpaid, it’s often turned over to a debt collector, whose job is to obtain payment of the debt.
If the collector is able to obtain payment from a customer, the original creditor (whoever the debt was owed to) will pay the debt collector a commission. Debt collectors, after going through a compliance process, can report negative information to credit reporting agencies.
In some cases, the account is sold to a debt buyer. This is especially true with credit card debts. If the debt is large enough, the debt buyer might sue you in court.
If you pay a collection / debt buyer account, the account should be marked as paid on your credit reports. Newer versions of FICO ignore or put less weight on paid collections.
However, older versions of FICO (including those used for mortgages), still count paid collections against your score. It thus makes sense to have paid collections accounts removed from your credit reports.
One way to accomplish this is by offering to pay the collection, in exchange for having it deleted from your credit reports. Not all collectors will agree to this, but many will. If they do, your credit score will improve.
Removing Negative Items From Your Credit Reports
As we have mentioned, 35% of your FICO score is your payment history. This considers not only whether you’ve paid accounts on time, but also, whether you paid late. Negative items like late payments, collections, charge offs and auto repossessions all cause considerable damage to your FICO score.
Fortunately, there is a process through which you might remove negative credit items. The Fair Credit Reporting Act (known as the FCRA) is the federal law which regulates credit reporting. The FCRA requires that all information on your credit reports be accurate, verifiable, timely and complete. If these requirements are not met, the items must be removed.
If you believe that information on your credit reports might not meet legal requirements, you have the right to have the information corrected or removed. You do this by disputing the items with the credit reporting agencies.
If not corrected, you might also dispute with the creditor or debt collector who placed the items on your credit report. If they still don’t correct, you might have grounds to sue the credit reporting agencies, along with the creditor or debt collector.
You can work on your credit on your own, or you can obtain the assistance of a credit repair company. Credit repair companies are sometimes led by attorneys, who have extensive experience in the laws concerning credit.
In other cases, credit specialists are not lawyers, but have educated themselves in the laws around credit and debt. Often, these professionals partner with attorneys, in the event a client’s rights are violated.
Credit repair companies have a variety of fee structures. Some charge a flat fee for work completed. Others charge a recurring monthly fee, for however long you’re in their program. Still others charge only per item removed.
There are good companies in each of these fee structures. Yet, it is worth noting that if you’re only paying for what is deleted, you’ll be aligned with the company who’s working on your credit. They don’t have an incentive to drag on the credit repair process (the way that some companies charging a monthly fee might).
You’ll want to research any company you hire. Read their reviews online, and find out about the backgrounds of those who started the company.
You should also understand your rights under the Credit Repair Organizations Act, the federal law which regulates credit repair companies. Amongst other things, the company you hire must provide you with a written contract, and inform you of your right to cancel the contract within a certain time period.
The credit repair process isn’t an immediate one. Most effective credit repair programs take at least 6 months, often longer. Your credit didn’t go back overnight, and so it won’t rebound immediately either.
The Final Word
When you’re dealing with damaged credit, it’s hard to know the best approach to improving your score. If you have an ambitious goal (such as buying a home), then you’ll probably feel additional pressure to improve your score.
The timeline for improving your credit can also create additional pressure, since you want to get your credit up as soon as possible. All of this can be very stressful.
Fortunately, you now have a roadmap. You know how to achieve your goals. If you follow all of the steps above, you’ll enjoy a great chance of becoming a homeowner, within 1 year. Time to get to work.
