Bad credit . . . it's a dark cloud that hangs over your head and finances. Whether your bad credit is from making misguided choices or hardships that were out of your control, it can make qualifying for a mortgage loan difficult and stressful.
Your credit score is basically a number showing how risky it is to lend you money and how likely it is that you will pay your obligations on time. Lenders want to make sure that when they loan out money, they are taking a smart risk and will be paid back. Since your credit score is based on your history of paying bills properly and on time, the higher your credit score, the more attractive you are to lenders, because they consider you more likely to pay your future bills and repay the money you borrow.
If you have bad credit, here's some good news: there are actions you can take now to help improve your credit score over time and demonstrate to lenders that you can be trusted to repay a home loan on schedule.
Improve your FICO® credit score
Think of improving your credit score as a marathon, not a sprint. It took time to get into a bad credit pickle, and it’s going to take time to get out of that situation and improve your scores. According to myFICO.com, 90% of top lenders use FICO® scores when making lending decisions. Therefore, improving your FICO score is key. Your score is one big factor financial institutions, companies, and lenders use to decide on a large range of requests involving money:
Here are a few tips that you can start implementing now:
Check your credit report. In particular, check to make sure that there are no late payments incorrectly listed for any of your accounts and that the amounts owed for each of your open accounts is correct. If you find errors on any of your reports, dispute them with the credit bureau immediately.
Set up payment reminders and pay your bills on time. Making your bill and credit payments on time is one of the biggest contributing factors to your credit scores. Some banks offer online banking portal payment reminders that can send you an alert reminding you when a payment is due. If you have missed payments, get current and stay current.
Reduce the amount of debt you owe by paying it off, not moving it around. Use your credit report to make a list of all of your accounts, then go online or check recent statements to determine how much you owe on each account and what interest rate is being applied. Come up with a payment plan that puts most of your available budget for debt payments toward the highest interest debt first, while still making at least minimum payments on your other accounts.
Consider your balance-to-limit ratios. To illustrate balance-to-limit ratios, let's say two different borrowers each have three credit cards with $5,000 credit limits and card balance totals of $4,500. Borrower 1 owes $4,500 on one card, with $0 balances on the other two cards. Borrower 2 owes $1,500 on three different cards. While the total debt is the same, borrower 1's credit will be impacted negatively by the fact that one card has a balance near the credit limit. Since borrower 2 has a much lower balance-to-limit ratio, borrower 2's credit score will be higher.
For additional tips, check out our 10-step guide for improving your credit score.
Demonstrate good payment history
Pay your rent and utilities on time each and every month. While your credit score may not climb to the highest number quite yet, consistently paying your monthly bills demonstrates to lenders that when it comes to these expenses, you can hold a job and can be a reliable borrower. Lenders want to ensure that you’re trustworthy when it comes to taking on a home loan and won’t leave them with a foreclosure situation!
Related reading: Good Credit: 5 Examples of Why it Matters
Seek an FHA loan
A Federal Housing Authority (FHA) loan is insured by the government and in most cases does not penalize borrowers for lower credit scores. Contrast this to conventional loans, which are likely to carry considerably higher interest rates and mortgage insurance rates at lower credit scores. Be prepared to provide a wide range of details (start by reading our Must-Have Documents to Apply for a Mortgage Loan) when filling out the application. Also, avoid making any large credit card purchases before applying. If you have poor credit, the FHA recommends you complete a consumer credit counseling program to help manage your debt before applying.
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