Many people want to become homeowners but shortchange themselves when it comes to qualifying. This is especially true with prospective first time home buyers who have not been through the process before. Often visions of being the perfect buyer scare someone into renting versus owning a home. Misunderstandings, such as needing a very high credit score and having large down payments run rampant in the minds of buyers. However, using a few very doable tips will help a first time home buyer get into a home with potentially minimal credit.
What Does Limited Credit Look Like?
When we say limited credit, we mean credit reporting to the credit bureaus. Every mortgage lender will pull a buyer’s credit report, which generally pulls all three bureaus. Just think, if a buyer wants to borrow $75,000, $100,000, or $200,000, lenders want to see a track history of paying bills on time.
Many buyers have credit files that lack depth or history for one of two reasons. First is just being young and not having time to establish much credit yet. Second, others are either afraid or misunderstand how credit works. Generally, there are four main characteristics of buyer profiles lacking in credit.
Characteristics of Limited Credit Profile
- A limited number of accounts reporting 12 months
- Lack of revolving credit accounts
- Authorized user accounts
- Misunderstand how credit works
Limited Number of Accounts
Lenders consider a good credit reference as one reporting at least 12 months. Hopefully, it is paid on-time as well. Good loan officers will count the number of credit accounts reporting 12+ months on a thin credit file.
We have found that many do not realize the power of revolving accounts. If you’re going to have only one credit account, it is best for it to be a revolving account. Typically, this is a credit card. 30% of a credit score is based on balance compared to the credit limit on revolving accounts. With no revolving accounts, that’s missing out on a lot of points!
Authorized User Accounts
Getting a creditor to step out on a limb and provide a first-time borrower with credit can be tough. Many times the first account is an authorized user account. This is basically borrowing someone else’s credit. The actual account holder is responsible for the payment and the authorized can use the card but has no financial responsibility. Sounds like a pretty sweet deal, right? There are downsides!
If the credit card account either has a late payment or has a high balance compared to the limit, then the user’s credit score will be negatively impacted. The problem is usually the user is not the one paying the account. In that case, the authorized user is at the mercy of the account holder’s habits and situation. So, be careful. Luckily, there is an easy fix when things go bad. If the account begins to cause a problem, just request removal from the account. Then it goes away from the user’s credit file like it never existed!
We have already discussed several areas that cause confusion in the game of credit scoring. The one that everyone knows is to pay your bills on time. When it comes to the effects of revolving accounts, authorized user accounts, and a mix of account types, many are confused. We see the conflicting and lousy advice all the time online. It is easy for individuals to get scared of establishing credit for fear of qualifying or just knowing how to do it. The good news is that it is possible to buy a house shortly after establishing credit when done correctly.
Remember, if a buyer has limited credit, the few accounts need to be paid promptly. A buyer with one trade line and recent late payments on that account will struggle for approval.
How to Buy a Home With Limited Credit
Now that you have a base knowledge of limited credit and maybe some of these sound familiar to your situation, let’s discuss 6 key factors to get a mortgage approval with minimal credit reporting to the bureaus.
- Pay down small credit card balances
- Accounts opened 12 months
- Provide alternative credit references
- Rent history
- Down Payment
- Use an experienced loan officer
Tip #1: Pay Down Credit Card Balances
We know from earlier that balances on credit cards make up 30% of a credit score. Additionally, the pay history on the card and other accounts make up for 35% of the score. A credit card possesses a lot of power, not only in a credit score but is also vital in the mortgage pre-approval.
Typically, a first credit card or two have low credit limits. $300 – $500 credit limits are common for first credit cards. Remembering our 30% tips above, imagine what a $270 balance does on a $300 credit limit. That is 90% of the limit! So, if that is the only account reporting, this will severely hamper a score. The good news is that score can be high again in about a month! Just pay the card down to under 10% of the limit for maximum points. A $30 balance on a $300 limit could literally mean 50 – 100 points on a credit score.
Tip #2: 12 Month Accounts
Credit experience takes time and the key number for mortgage lenders is 12. For limited credit buyers, lenders are counting the number of accounts reporting 12 months. The longer the accounts are open, the better it is. This is known credit depth. The magic number lenders are looking for are 3 – 4 credit accounts that have been opened at least 12 months. Although it is best for these to report on the 3 major credit bureaus, some may be alternative credit sources.
Tip #3: Alternative Credit
Alternative credit references are credit accounts in the borrower’s name which do not report to the credit bureaus. In the case of insufficient credit reporting 12 months or more, alternative credit often moves a buyer from a credit denial to a mortgage pre-approval! Here are some examples of acceptable alternative credit sources.
- Rent history (although some companies report to credit bureaus)
- Insurances (auto, boat, health, life, disability) – not payroll deducted
- Cell phone
- Xbox Live, Apple
- Small store accounts
- Buy here pay here car loans
- Consistent savings pattern
Proving Alternative Credit References
To prove alternative credit, we have a couple of options. A buyer could contact the creditor for a credit reference. The credit reference letter must provide at least a 12-month payment history. Also, make sure that the company name, phone number, and account number are provided. We must verify the information.
Another way of verifying alternative credit would be to provide us with the company name, phone number, and account number for each alternative source. Then, we order a credit supplement which will add these items to a credit report. Keep in mind these will not affect the credit score and only serve as an internal way of building a credit file. The credit reporting company will make a conference call between them, the buyer, and the creditor to verify the history details. The result is hopefully a sufficient amount of credit for loan approval. Again, typically looking for 3 -4 total accounts. However, there are exceptions so don’t disqualify yourself!
Tip #4: Rent History
Probably the biggest indicator for making a mortgage payment on time, other than credit score, is rent history. A buyer who proves a prior housing history that is paid well, makes a lender feel more confident in the approval process. Now, buyers with well-established credit history often do not have to prove rental history. When limited credit is involved, rent history could be the one factor that makes the difference.
The best rent history practices
- Rent paid to a company
- Pay rent by check or bank draft
- Low payment shock – rent payment is similar to the potential new mortgage payment
Just because a buyer doesn’t have the above, doesn’t mean denial. There are times a rental verification from an individual landlord works. An alternative that may work is proving cash withdrawals over the last 12 months bank statements that equal the rent amount. This option may bring up other issues but is an option that has worked a good number of times for buyers.
Tip #5: Down Payment
Good credit and rental history go a long ways towards getting loan approval. However, assets are one of the most overlooked areas for turning a denial into a mortgage approval. There are great mortgage programs that offer no down payment for buyers with limited credit. Assets go a long way towards those and other approvals.
How Assets Help No Money Down Approvals
A buyer usually thinks, “Why do I need to prove assets on a no money down purchase?”. Most mortgage approvals start through an automated underwriting system. These include Fannie Mae’s Desktop Underwriter, Freddie Mac’s Loan Prospector, and USDA’s Guaranteed Underwriting System. The goal of a loan officer running these systems is to get an automated approval.
USDA and VA Loan Asset Reserves
Automated approvals love assets. Basically, automated systems weigh risk factors versus compensating factors. Let’s use a VA loan with no money down as an example. If a buyer has limited credit and no asset reserves, the automated system may not offer a pre-approval. However, if a buyer has funds in checking, savings, retirement account or other asset accounts, it could change the file status. Often, a couple of months of mortgage payments in assets will help the loan approval. Plus, using VA seller paid closing costs as a strategy could improve chances of loan approval.
FHA and Conventional Loan Asset Reserves
Just like above, asset reserves will often make a good difference in loan approvals. For the down payment, funds may typically come from other sources, such as gift funds. Although gift funds are allowed, when a buyer uses their funds for down payment, underwriting services look favorably on this. With limited credit buyers or lower credit scores, using buyer’s funds will often make the difference.
Tip #6: Use an Experienced Loan Officer
OVM Financial loan officers will thoroughly look for loan options as well as discuss strategies for best loan options. We promise to explore all possible options at our disposal. Contact us to start the first step towards buying your first home!