With consumer confidence in the housing market hitting its highest level on record, you shouldn’t let a below-average credit score discourage you from pursuing home ownership.
Although most lenders would prefer a larger down payment and a credit score north of 720, you can still qualify for an FHA or VA loan with below-average (and even poor) credit.
FICO, VantageScore, and You
A credit score measures consumer credit risk based on your credit and payment history, and scores range from 300 to 850. The higher your score, the better, and currently more than half of consumers have a score higher than 700, which is considered good. Above 740 is considered to be excellent.
Major lenders continue to rely on FICO scores to determine loan eligibility, but FICO scores tend to be very modest compared to the scores reported by VantageScore, the credit reporting system started by TransUnion, Equifax Inc., and Experian. Whereas FICO needs six months of credit history to even establish a credit score, VantageScore can churn out a credit score with just one month of history.
Both FICO and VantageScore consider your payment history to be the most important factor in determining your score, but there are some major differences in how the two determine that score. Whereas FICO judges all late payments the same, VantageScore treats different credit accounts differently (with late mortgage payments playing a greater role in damaging your credit). For VantageScore, the age and type of credit, as well as the percentage of credit used, are considered most important after payment history. For FICO, the amount of money you owe is most important after payment history in determining your score.
Things are looking up thanks to VantageScore, however, as non-bank lenders are fighting to be able to use VantageScore in loan eligibility determination in order to help more people become homeowners. For now, however, lenders will continue to rely on your FICO score to determine whether you qualify for an FHA or VA loan.
Qualifying for an FHA Loan
The government-backed Federal Housing Administration (FHA) loan is the best option for homebuyers with below-average credit who are not veterans, qualified spouses, or active-duty service members. Here are the guidelines regarding your FICO credit score:
- If your FICO score is lower than 520, you will be unable to qualify for an FHA loan—period.
- If your FICO score is lower than 580, it is possible to qualify for an FHA loan with at least 10 percent down.
- If your FICO score is 580 or greater, you can usually qualify with only a 3.5 percent down payment.
Consumer Tip: Don't just accept an FHA loan denial. Many lenders are still capped at a minimum credit score of 620 but this is due to their internal underwriting criteria and NOT what FHA or VA actually allow.
Here are some pros and cons to securing an FHA loan, including:
- Pro: For borrowers with lower FICO scores, FHA loans often come with much lower interest rates and mortgage insurance rates.
- Pro: The FHA loan is assumable by another borrower. That means that if you have a smokin' good rate and you sell your home, the borrower can just "assume" your loan and payment. Cool huh?
- Con: The FHA has a whopper of an upfront fee (that you finance) which eats up 1.75% of your down payment.
- Con: The FHA has monthly mortgage insurance. This insurance never goes away and it doesn't matter how much money you put down or what your home is work. You have an FHA loan, you must have mortgage insurance.
- Pro: Most of the typical rules of engagement go out the window with regards to the stiff debt to income requirements or even how some credit events are looked at. Bottom line, the FHA loan is easier to qualify for.
It’s also important to know that beyond being possible to qualify for an FHA loan with a below-average credit score, lenders make other considerations you should be aware of, including:
- Employment History: Although the FHA doesn’t have any employment requirements, your lender may require you to submit an employment history and require that you be consistently employed for at least six months with the same company in the same location.
- Credit History: The FHA doesn’t disqualify applications based on bad or no credit history, but lenders may require an established credit history or look at your payment history for rent and utilities.
- Debt-to-Income Ratio: Even though the FHA may allow a debt-to-income ratio of more than 43 percent, most lenders are not as generous.
- Collections: Lenders may require you to have a zero balance with any accounts in collections, although the FHA has no set requirements regarding collections.
These additional considerations protect lenders from having to deal with the consequences of borrowers going into default or foreclosure, including potentially losing FHA-approved status.
Qualifying for a VA Loan
For members of the military, their qualifying spouses, and veterans, a Department of Veterans Affairs (VA) loan is a no-brainer. VA loans can be used to buy or build a home, complete renovations and repairs such as energy-efficient improvements, refinance an existing mortgage, and more.
VA loans are considered a benefit to veterans and military personnel, so they are less restrictive than conventional loans and are much cheaper than the FHA loan. The main perks of a VA loan include:
- Little to no down payment required
- No need for private mortgage insurance
- Low closing costs
- Ability to easily refinance
To qualify for a VA loan, you must have sufficient income, a valid Certificate of Eligibility, and satisfactory credit. But what does satisfactory credit look like for a VA loan?
Lenders look for a FICO score of at least 620, although some will consider a score of 580. However, although the VA doesn’t actually lend money for VA loans, the organization guarantees a portion of the loan made by a lender in case the borrower defaults on the mortgage. This means lenders tend to be more flexible with lending terms, which could make it easier for you to qualify for a VA loan with less-than-perfect credit.
To find out whether you qualify for an FHA or VA loan with below-average credit, schedule your free consultation with Rick Elmendorf and his team today.