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People With Terrible Credit Should Not Apply for Home Loans
By Brandon Cornett
© 2011 All rights reservedPeople with terrible credit have been lied to for a long time, with regard to mortgage loans and home buying. And I'm going to stop that cycle right here and now.
If you truly have a terrible credit score, the worst thing you can do is take on a mortgage loan. The best thing you can do is improve your score first, before you start applying for home loans. In this article, I'll explain what happens in each of these scenarios.
First, let us loosely define what a terrible credit score is in the first place. There are actually different scoring models in use today (FICO being the most common), and lenders have different standards from one another. So it's hard to put an exact number on "terrible" credit. So let's just say that it's a score far below the national average. So, for example, if the average credit score in the U.S. were 700, a terrible score might be considered something in the 450 range.
If you fall into this category, you should know that you're not alone. Not by a long shot. Millions of Americans have credit problems these days. It's a serious economic issue in this country. But you shouldn't take comfort in that either, because it's not a "crowd" you want to be in — not any longer. And that's why I am writing this article. I truly feel that getting a home loan with terrible credit is a recipe for continued credit problems. In other words, it makes it even harder for you to fix the problem. Let me explain why by offering two different home buying scenarios:
Scenario #1 - Getting a Home Loan With Terrible Credit
Let me preface this scenario by saying it would be a near miracle if you could even get a mortgage loan with a terrible credit in this economy. I am writing this article at the end of 2008, and right now there are few (if any) lenders who will even consider offering a home loan to people with terrible credit scores. Why? Because that's primarily what led to the economic crisis we are slogging through right now — subprime loans given to millions of people with credit problems.
But let's assume you could get approved for a mortgage loan with such a score. Let me explain what would most likely happen. And keep in mind, this is not a wild guess I'm making here. This is exactly what happened to record-breaking numbers of homeowners from 2007 - 2009. Here's the scenario.
- You approach a lender to apply for a home loan, but you get turned away because of your terrible credit.
- So you approach a different mortgage lender, and another and another ... until you find one willing to offer you a home loan despite your low score.
- The lender who is finally willing to work with you will be offering you a subprime loan because of your terrible credit.
- Because you present a big risk to the bank, they will assign a very high interest rate to your loan (higher than what they would offer to a well-qualified borrower).
- That higher mortgage rate means a larger payment each month. But these subprime lenders have a trick up their sleeve to make it seem more affordable. It's called the ARM loan.
- There's a good chance the lender will give you an adjustable mortgage with a low initial fixed rate, often referred to as a "teaser" rate.
- After 3 - 5 years, however, that interest rate would adjust to a higher rate. The ARM loan essentially defers the high interest until after the reset point.
- Now you have a mortgage payment you can no longer afford, so you are faced with four options: (1) sell the home, (2) refinance the loan, (3) start making more money, or (4) face a foreclosure process.
- If you still have terrible credit (and/or if your home's value has dropped since you bought it), the refinancing option is off the table. This means you must either sell the home or start making more money to be able to afford it. Otherwise, you are going to be foreclosed upon.
How common is this scenario in today's economy? Very common. In October 2008, for example, there were nearly 85,000 home foreclosures across the United States. And those were just the ones that were captured by the data trackers who monitor these trends. In reality, there were probably more than 100,000 ... in one month alone.
The majority of those people who were foreclosed upon fell into the ARM loan scenario that I explained above. They had terrible credit scores, so they had to get adjustable mortgages from a subprime lender. The initial interest rate was manageable for the homeowners. But when the rates reset, the mortgage payments swelled up considerably.
The other part of the "one-two punch" was the fact that property values dropped in many areas as well. This made it hard to sell the home or refinance the loan. So, these people had two "choices" — start making a lot more money, or lose your home to foreclosure. The rest is housing crisis history.
So what happens to these people after foreclosure? Well, if they had terrible credit before thee events, it will only get worse afterward. When a lender forecloses on your home, that event will stay on your credit report for up to seven years. And obviously, it has a negative impact on your score.
Now you can see why I warn people with bad credit away from home buying, at least until they can improve their credit situation. If you can exercise some financial discipline, it really doesn't take that long to improve a terrible score. I've even put together a video tutorial on how to go about it. Check it out below:
Now let's talk about the other scenario. Let's look at what happens when you put home buying on the side burner for now, and focus on improving your credit situation first.
Scenario #2 - Improving Your Credit Before Buying
As you can see from the video above, it's not that hard to repair bad credit if you have a plan of attack (and the financial discipline to make it happen). Also, if you do improve your score before applying for a mortgage, you'll be in much better shape.
Let's say you really put forth an effort, and you're able to turn your terrible credit score into a good one ... maybe something in the 720 - 750 range. Here's a new scenario to show what will likely happen during the process:
- You will probably get approved for a loan by the first lender you approach, as long as the amount of the loan is reasonable for your income level.
- Because of that newly improved credit score, you'll probably qualify for the lender's best / lowest interest rate as well.
- Having a lower rate on the loan will make it much more affordable. So you probably won't have to resort to the riskier ARM loan. You can probably afford to start off with the more predictable fixed-rate mortgage.
- With a fixed-rate loan, you will never run into a spike in the interest rate, like I described in scenario #1 above. Your mortgage will carry the same interest rate over the life of the loan. So the payment will stay the same as well.
- Give these factors, you will be in a much better position financially and will not face any unpleasant surprises down the road (like a mortgage payment that swells up on you).
- Your overall financial picture is probably in better shape now too, because of the things you did to improve your terrible credit score — such as reducing your debt, making all bill payments on time, fixing errors on your credit reports, etc.
Now given the two real-world scenarios presented above, which one seems like the best path for you? Credit problems are not permanent. They can be changed for the better, and it's something you have complete control over. It's far better to improve your financial situation before trying to buy a house, because a mortgage payment usually only makes matters worse.
On the other hand, if you can fix that terrible credit score before applying for a loan, you'll get a more affordable mortgage (among other things).
Brandon Cornett is the creator of the Home Buying Institute. He created this section of the website to help people with bad credit get back on track. If you have a low credit score and are trying to improve, check out this related section of our website.
