Loan types for borrowers with poor credit

By Michele Lerner
Mortgage Credit Problems Columnist

Mortgage lenders today set high qualifying standards for borrowers, who need to provide documentation of income and assets that prove they can afford to repay the loan. For borrowers with less-than-perfect credit, a poor credit mortgage may be necessary.

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Conventional loans require a significant down payment and good to excellent credit scores to qualify for the lowest interest rates. These days, getting a conventional loan with poor credit is difficult at best and costly. Fannie Mae and Freddie Mac have added what are called Loan-Level Pricing Adjustments, which are essentially fees charged to make up for high-risk factors on the property or the borrower.

For instance, as of December 2011, if you have a credit score below 620 and apply for a conventional mortgage with 10 percent down under Fannie Mae guidelines, you'll pay an additional 3.25 percent of the loan amount more than someone who has a 740-plus credit score and 25 percent down. That 3.25 percent will translate to a higher interest rate.

Mortgage alternatives for poor-credit borrowers

Borrowers with poor credit may be able to qualify for an FHA loan, which is insured by the Federal Housing Administration. Credit score requirements vary by lender. Though the FHA will back loans for borrowers with credit scores as low as 500, typically FHA lenders will qualify borrowers with a score of 620 or above for an FHA loan, provided they meet other qualification requirements.

Bad credit mortgage lenders can also work with borrowers who have the income and assets to qualify for a loan, but have a low credit score. Qualifying in this case depends in part on the reasons for the bad credit. Credit problems due to a period of unemployment or illness followed by improving credit may be more acceptable to lenders than a low credit score due to overspending and late payments.

If, instead, your credit score issues are because you have mismanaged your money:

  • You may have to apply with more than one lender to find one who will approve a mortgage for bad credit.
  • You should immediately begin paying past-due balances, reducing the amount of credit in use, and paying all bills on time in order to raise your credit score.
  • Even if you qualify for a new home loan, you will have to pay higher interest rates than borrowers with better credit.
  • You can ask a friend or relative with better credit to co-sign a mortgage application. However, the co-signer is then obligated to pay the loan if you default, so make sure you are truly able to keep up with the loan payments.

While your credit history is extremely important for a loan approval, you also need to have high enough income so that the entire housing payment (principal, interest, taxes, insurance and homeowner fees) stays under approximately 30 percent of your monthly gross income.

Paying off debt and increasing your savings are vital to improving your chances of a home loan approval.

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