Jumping into the real estate market for the very first time can be a little scary at first. For some, anyway. Why? There are several reasons.
For one, buying a home is no small purchase and will likely be the biggest financial decision first time home buyers will make. If someone thought buying a new car was expensive, the prospect of buying a home is an even greater commitment.
Second, it’s an entirely new process and the lending industry uses terms typically not used in everyday conversations.
Third, the amount of paperwork required might be surprising. But once the future home owners get into the loan approval process the air begins to clear a little bit and soon the pre approval letter is in hand. Yet one more piece of the approval process involves credit scores, how they’re calculated and how lenders use them. But credit scores really aren’t that difficult to interpret once you know how they’re calculated. But what if a credit score is low? What if buyers have a low credit score and they’re not sure if they can get a loan approval?
Credit Scores : The Factors
Credit scores range from 300 to 850 and are calculated using an algorithm based upon five separate factors – Payment history, Available balance, Length of credit history, Types of credit and Credit inquiries. Each category contributes a different amount to the final score.
- Payment history (35%) involves when payments were made. When consumers open up a credit account and borrows money or charges something on a credit card and the due date is on the first of every month, if the payment is made on or before the due date, credit scores improve. When payments are made more than 30 days past the due date, scores will begin to fall. They will fall further if payments are made more than 60 and 90 days past. Finally, accounts that are sent to collections or even to court to obtain a judgement, scores drop further still.
- Available balance (30%) compares the outstanding balance with the credit line. Consumers who keep an outstanding balance around one-third of the credit limit will see their scores improve. When balances approach the credit limit, scores will begin to fall. Going over the credit limit, even if the payment was made on time, will push scores lower still.
- Length of credit (15%) simply means how long someone has had credit. The older the credit history, the better the credit score.
- Types of credit (10%) involves consumers using different types of credit accounts responsibly such as a credit card or an automobile loan. Consumers who take out unsecured loans from finance companies, usually reserved for those with damaged credit, will find their scores falling.
- Credit inquiries (10%) count against a consumer when there are multiple applications for new credit within a relatively short period of time, possibly indicating the individual is having some financial issues.
Low Credit Scores and Loan Approval
Lenders refer to a matrix that shows a mix of acceptable credit scores along with the amount of a down payment. For someone with a credit score of 740 or higher, lenders can approve a conventional loan with just a 5.0% down payment. Yet for someone with lower credit scores, the interest rate on a loan will be slightly higher for someone with say a credit score of 620. For credit scores below 620, it can be difficult, but not impossible to obtain a loan approval.
First however, don’t assume you have poor credit or low scores. The only way to find out what your score really is means contacting a loan officer and submitting a loan application with an authorization to pull credit. Once the scores come in, your loan officer can put together a game plan.
Let’s say someone’s score is below 620. The qualifying credit score might be 600. Lenders can override the interest rate matrix at their discretion as long as the factors that are driving down the credit score are only temporary and are on the mend. For example, someone might have had an extended illness and the bills started piling up. But the person got better and went back to work and all is well. The lender can document this and include the documentation in the file and approve the loan due to the compensating factors of an illness and lack of income.
There are also situations where lenders can approve a loan with a credit score as low as 580. Most government-backed loan programs such as FHA and VA allow for a loan approval with scores as low as 600 and with extenuating circumstances as low as 580. Note that these lower scores are at the discretion of the lender.
Further, FHA and VA do not require a specific score, only that the lender make the determination the borrower will make the mortgage payments on time. With low scores, the loan officer will recommend a government-backed loan program. Even if someone has had a recent bankruptcy, with proper documentation a loan can still be approved.
For example, FHA has a special “Back to Work” program that allows someone to get a loan approval without having to wait the standard two years since the bankruptcy discharge and only have to wait one year.
This program requires extensive documentation regarding the event(s) that led to the bankruptcy as well as show the income declined by at least 20 percent before a bankruptcy, loss of job or illness. Credit must also be reestablished showing timely rental payments as well as on time payments over the previous 12 months. Or, borrowers can simply wait while repairing their credit. It doesn’t take very long for credit scores to be on the mend. If someone can’t get a loan approval due to low credit scores or they want to get a better rate with a lower down payment, simply making on-time payments and whittling down loan balances to one-third of credit lines, scores will begin to improve within 30-60 days.
Finally, and perhaps most important, don’t pass judgement on your credit situation on your own. Let an experienced loan officer take a look at your situation and work out a path that will get your scores where they need to be. You might have low scores now, but with proper guidance, they won’t be for long.
