Buying a home is one of the best investments you can make. Owning your own home is a great way to build equity and a foundation for your financial life. If you have a low credit score, however, you may find it difficult to get a mortgage. There are home loans available that can help you purchase a home, even if your credit is less than perfect.

Loan Options for Low-Credit-Score Buyers

Securing a mortgage loan doesn't depend solely on your credit score. Lenders will also take into account other factors, such as your income, your savings, and your credit history. Generally speaking, your ability to acquire a mortgage and the interest rate and terms of the loan depends on a combination of these factors.

FHA Loans

Many banks will not consider you for a mortgage if you have a score of under 580. If your credit score is less than 580, an FHA loan is probably your best option. For this type of mortgage, you will need a credit score of at least 500.

What Is an FHA Loan?

This is a mortgage loan that is guaranteed by the Federal Housing Authority, a government agency that assists buyers with low income, limited down payment funds, or low credit scores to purchase a primary residence. The FHA doesn't loan money to borrowers but rather gives the lending bank a promise that the loan will be paid in case a buyer defaults on the payments.

This guarantee means that the bank can offer qualifying buyers more open terms on a mortgage with less risk. FHA loans offer buyers more flexible options, such as a low down payment option, a lower interest rate, or a mortgage loan in spite of poor credit.

How Does an FHA Loan Work?

You apply for an FHA loan at a regular bank. Not all banks offer this type of loan, but many do. If your credit score is 580 or higher, you will only need 3.5% for a down payment to get a rate, compared to a conventional mortgage rate requiring 20% down.

If your credit score is between 500 and 580, you will need a larger down payment, generally 10% or more. You need a credit score of at least 500 to apply for an FHA loan, even with a higher percentage to put down.

What Are the Conditions of an FHA Loan?

FHA loans can only be used for a primary residence. You cannot, for example, take out an FHA mortgage for a rental income property or a vacation home. FHA loans require that you pay insurance on the loan as well.

What Insurance Is Needed for FHA Loans?

The required mortgage insurance premium is broken into two parts. There is a fixed fee of 1.75% of the loan amount that you either pay upfront with other closing costs or roll into the loan. If you include this cost in the loan, it raises your borrowed amount by 1.75%. This makes a small increase in your monthly mortgage payment.

There is also an annual MIP payment, which is an amount calculated each year, then spread out over the 12 months and added to your monthly payment. Typically, the annual MIP is under 1% of the amount owed; in most situations, it is 0.85%.

Here's an example of how this affects your payments: If you borrow $200,000, the annual MIP would come to $1,700. Divided over 12 months, this insurance would increase your monthly payment by $141.67.

If you put down 10%, MIP insurance is paid for the first 11 years of the mortgage. If you put down less than 10%, MIP is required for the length of the loan. To remove the cost of MIP, many borrowers will refinance to a conventional mortgage once they have built some equity in the property and improved their credit rating.

VA Loans

If you are a veteran, a VA loan is an excellent option for a low-credit-score mortgage. Unlike conventional mortgages, VA loans don't require a down payment to secure an excellent interest rate. Generally, VA loans are only offered to borrowers with a credit score of 580 and above, although the specific cutoff is up to the issuing bank.

If you have little or no down payment, a VA loan is usually your best option to get an advantageous interest rate. Mortgage insurance is not required for a VA loan, which can save you a significant amount of money each month.

For most veterans, a VA mortgage loan offers the best rates and terms.

In-House or Non-Qualified Mortgage

If your credit score is under 620, the other mortgage loan type that you may qualify for is known as a non-qualified mortgage. This is simply a loan that the bank holds in house. There are no set terms beyond what you and the bank decide.

Most mortgage loans are sold to the secondary market and must meet the criteria for buyers of mortgage debt. Occasionally, however, a bank will issue a loan from its own funds. These loans are uncommon, but they may be an option if the bank determines that you are a good risk in spite of your lower credit score.

Expect to pay a significantly higher interest rate on a loan of this type versus a conventional mortgage loan. Additionally, you will probably be required to carry private mortgage insurance if you aren't able to put down more than 20%.

Other Loan Programs for Slightly Higher Credit Ratings

If your credit rating is a little higher, you may qualify for other government-backed loan programs such as the HomeReady program from Fannie Mae or the Home Possible program from Freddie Mac. These mortgage loans require a credit score of 620 or 660, respectively, and are designed for people who cannot afford large down payments or who are buying their first home.

Information for Home Buyers With Low Credit Scores

If you are interested in buying a home and you're not sure of your options or you have questions about the process, we can help. At FHA Insider, we provide clear information about securing a mortgage in today's competitive market. Contact us today for answers and professional guidance to help you purchase a home of your own.