4 Tips for Prospective Homebuyers with Poor Credit

4 Tips for Prospective Homebuyers with Poor Credit
GUIDE
Tali Wee
By: Tali Wee
Posted: February 2, 2015
BadCredit.org's popular "How-To" series is for those who seek to improve, rebuild or better understand their subprime credit rating.

Prospective homebuyers have numerous financial elements to consider before shopping for homes.

The first step is loan prequalification, when lenders review potential borrowers’ financial health to establish a ballpark loan amount. Next, borrowers can submit loan applications for lenders to thoroughly evaluate their finances, including their credit scores.

Lenders offer the most favorable loan types and interest rates to shoppers with the lowest risk of defaulting. Credit scores rank borrowers’ risk on a scale of 300 to 850, with 850 being the lowest risk.

Borrowers with credit scores below 620 may experience difficulty qualifying for mortgages. However, some institutions offer home loans specifically to borrowers with bad credit.

Therefore, borrowers with bad credit must reduce risk in other areas to acquire reasonable loan terms. Begin by reviewing your credit score and then following these four risk reducing recommendations.

1. Stabilize financial history

Borrowers should avoid major changes to their financial records in the two years prior to home purchase. Lenders are more comfortable loaning money to borrowers with bad credit if they have stable income, long-term employment and consistently-paid bills.

Don’t apply for new lines of credit or cancel any credit cards within six months of applying for a mortgage. Be prepared to justify all credit changes in recent years.

2. Save for down payment and reserves

Lenders assume less risk when borrowers pay larger down payments. A standard guideline for down payment size is 20 percent of the total home price, also known as 80 percent loan-to-value ratio (LTV). The lower the LTV, the more favorable the loan terms for borrowers with poor credit. Calculate LTV ratios by dividing the loan amount by the total home price.

Some loan types require no money down (100 percent LTV) while others require 10 percent down (90 percent LTV). Borrowers with low credit should offer higher down payments than their loan types require to reduce lender risk.

Keep in mind, LTV ratios of 80 percent or higher charge additional monthly costs for mortgage insurance. More money down is both appealing to lenders and saves borrowers money over the life of the loan.

However, don’t apply all savings toward the down payment because lenders still want to see their borrowers with enough remaining money to pay two to six months of their mortgages. Lenders determine total months of reserves by borrowers’ risk level.

3. Reduce recurring debts

Another percentage lenders review is debt-to-income (DTI) ratio. Calculate DTI by adding all monthly debts, including rent, student loans, credit card bills, car payments, utilities and other bills. Divide total monthly debt by gross monthly income to determine DTI.

Borrowers with DTI ratios of 45 percent meet the qualifications for popular loan types. Borrowers with bad credit should aim for 36 percent or lower to appeal to lenders. Decrease DTI ratios by paying off credit card balances and reducing monthly bills.

4. Opt for low-risk properties

Lenders are more likely to loan funds to borrowers purchasing owner-occupied, single-family homes than other properties. Second homes and rental properties are higher risk purchases because borrowers likely have other mortgages to pay and may face months without rental property income.

Furthermore, homeowners associations related to condos bring an additional financial burden to borrowers’ overall financial pictures. Borrowers with poor credit should focus on the lowest risk properties for the best loan options.

Homebuyers with bad credit face more expensive loan scenarios but often can still find fair loan terms, especially when managing their finances to eliminate red flags. Visit Zillow to learn more about financing your next home.

Photo credit: askhomesale.com