“I have terrible credit, so I can’t purchase a house.” This is a common complaint among would-be homeowners. If they don’t say it, they think it—and continue paying rent without considering whether their assumption is true.
Many people think that being 30 days late on a credit card payment puts an indelible blot on their credit history, dooming them forever in the world of credit. Others believe that they won’t be able to get a mortgage because their credit report has some bruises and blemishes, so they don’t ever apply, fearing rejection. This is what we call a “self-fulfilling prophesy.”
Let’s clarify what constitutes “bad credit” and talk about what mortgage lenders require in a prospective borrower’s credit history. Lenders almost universally use the FICO score to assess the credit risk presented by people applying for loans. It is a three-digit number between 300 (terrible) and 850 (phenomenal), generated by a computer based on information in one’s credit report. Contrary to popular belief, lenders do NOT expect perfection in those hoping to borrow money from them. For a conventional loan (one that ultimately will be sold to Fannie Mae or Freddie Mac), the minimum for loan approval is 620. That number is even lower for federally-insured FHA loans; applicants can have a score as low as 580. What does a 620 score look like? After reviewing thousands of credit reports over the years, we know that a borrower with a 620 score must have some combination of the following:
- Recent past-due payments (30-days late or more)
- Accounts that are currently delinquent
- Collection accounts
- Liens and/or court judgments
- High credit card balances
- A borrower with a 620 (or even 580) score is eligible for mortgage financing, but there are some facts to be aware of.
First, the lender will require that delinquent accounts be brought current, and that collection accounts and judgments be settled. This is the case regardless of credit scores. Ironically, for many borrowers, settling these accounts will raise the credit score—sometimes by a lot.
Second, know that the money will be more expensive for a lower-score borrower. Lenders use “risk-based pricing,” where they adjust the borrower’s interest rate according to a combination of FICO score and loan-to-value ratio. A borrower with a 620 score will get a rate approximately .75% higher than will someone with a 740 score. What about those unfortunate souls whose credit reports are even below 580? Is there any hope at all for them?
There is always hope, but getting out of FICO prison requires some thought—and a plan. Here is the plan:
Step 1: Know where you are now. Get a copy of your credit report. You can do this at no cost by going to a site like CreditKarma.com. Print out your report. Mark all the negative items in red.
Step 2: Number the negative items in order of severity, starting with collection accounts, liens, and judgments. Accounts that are reported as past due come next. Then, look for credit card accounts whose balances are over their limit. Finally, number credit card accounts whose balances are more than 30% of their limit.
Step 3: (This may be the hardest—but it’s necessary): Get in touch with any collection agencies listed on your credit report. Negotiate a payment to settle the accounts in full. They may refuse at first, but be persistent. Collection agencies get a commission for settling accounts. Important: Do NOT agree to an immediate “check by phone” to settle the account. Don’t give them any money before getting a written agreement for a complete settlement. Be aware that the IRS will consider that any reduction of the balance to be income, and you’ll have to pay tax on it.
Step 4: Work on settling any judgments or liens. Since these are items in the public record, you don’t have as much chance of a reduced settlement—but you don’t have anything to lose by asking the judgment creditors to give you a break.
You’ll need cash for steps 3 and 4, but you’ll have to settle those kinds of items to get a mortgage from any lender.
Step 5: Bring delinquent accounts current. This step alone can add 25 points or more to your score. If any of the delinquent accounts are revolving (credit cards) and over your credit limit, the improvement could be more dramatic.
Step 6: Work on reducing credit card balances below 30% of the credit limits. Balances on revolving accounts make up about 30% of your score. This is called “credit utilization.” You may also be able to lower that percentage by increasing your credit limit; if you owe $1,500 on a card with a $3,000 limit, getting a credit line increase to $5,000 will drop your percentage to 30% from 50%, so your score should improve.
There are some actions that won’t do you any good:
- Getting a “cosigner.” Although you can have someone apply for the loan with you—this person is called a non-occupant co-borrower—this tactic won’t help you with poor credit. The lender will always use the lower score in its credit decision.
- Disputing every negative item on your credit report. While you have a right to dispute incorrect items under the Fair Credit Reporting Act, each dispute will appear on your credit until it is resolved. If the lender sees an unresolved dispute, they’ll require that you remove it before they’ll approve your loan.
- Showing that you have a large sum of money in the bank. Although your wealthy Uncle Murray might be willing to “park” a large sum of cash in your bank, it won’t help your loan approval or credit score. Besides—you’ll have to explain any large deposits appearing on your bank statements.
These steps may seem like a lot of work. They are. The fact is, it’s easier to get into difficulty with your credit score than to get out of it. But taking these steps—however long it may take—will provide enormous benefits.
And the “prize” of home ownership may be closer than you think.
Please, as always, reach out to me with any questions or issues. I'm always here to help.