If you are a low credit borrower, getting a mortgage is going to pose slightly more difficult for you than the person next to you with stellar credit. Your credit report shows the world your level of financial responsibility. If your credit score is low, lenders automatically think you are not responsible with your money and are a high risk when it comes to mortgage lending. This may or may not be the case for you, depending on what happened in the recent past with the economy taking a turn for the worse and the housing industry falling apart. Now that everyone is picking up the pieces, many borrowers are trying to find a way to get back into a home; the two options they typically have are an FHA loan or a subprime loan, if they have a low credit score.
FHA Home Loan Programs
FHA loans have a general requirement of a minimum credit score of 580, but you will not find many lenders that will accept a credit score that low – but they are out there. More and more lenders are turning to borrowers that have a lower credit score, yet other compensating factors that make them less risky than their credit score makes them look. If a bank decides not to implement an investor overlay in regards to the credit score, you may find that an FHA loan is available to you. These compensating factors include steady income, a low debt-to-income ratio, and assets/reserves in your possession. Aside from the steady income, these items are not necessarily required by FHA to qualify for a loan, but many banks will require them in order to offset the risk of the lower credit score.
FHA loans offer a different type of loan than a subprime loan would offer though. FHA requiresmortgage insurance in the event that you do default on the loan. This fact makes it easier for lenders to decide to give you the FHA loan with a more lucrative interest rate and typically better terms than you would find with a subprime loan. The mortgage insurance is a major player in the game, however, as it can add several hundred dollars to your monthlypayment, depending on the amount of your loan. In addition, FHA loans require upfront mortgage insurance, which is 1.75% of your loan amount. This can be a costly closing cost, but it helps you get into a loan with a low interest rate and the guarantee that the FHA provides. It also protects you by providing you with a “Qualified Mortgage” rather than a riskier loan that a bank is going to either keep on their own portfolio or that a secondary investor has guaranteed to purchase that has higher rates and less desirable terms. Something to keep in mind with mortgage insurance on FHA loans, is the fact that you will have it for the life of the loan unless you are in the minority that puts at least 10% down on the house, in which case you would only be liable for the mortgage insurance payments for 11 years. The amount of the mortgage insurance will vary for each loan as it is 0.85% of the loan amount; that total is then divided up amongst your 12 monthly payments, which is how your mortgage payment gets higher than the principal and interest.
Non-Qualified Mortgage Loans
Subprime loans are a completely different loan than FHA loans. The only thing they have in common is they accept lower credit scores. These loans are not part of the Qualified Mortgage program and likely have terms that are considered undesirable in many cases. They also have much higher interest rates than would be the case if you were getting a conforming or FHA loan. These loans do still have to abide by some rules. For example, they have to abide by the Ability to Repay Rule. This rule basically ensures that you can afford the loan are not just being provided the loan in order for the lender to make a quick profit while putting you into a financial bind. The lender still has the responsibility to carefully evaluate your financialsituation to determine if you could afford the loan. This means determining that you have adequate income that is supposed to continue for the foreseeable future; plenty of assets; the ability to care for any court ordered debts; and a reasonable debt-to-income ratio.
Lenders do still have the ability to provide loans for borrowers that exceed the Qualified Mortgage Rule of a 43% maximum debt ratio or provide loans with risky terms, such as interest only payments or rates that will adjust. Lenders will not be backed up in the case of default on these loans, however, as they do not meet the Qualified Mortgage guidelines. This could mean that the lender will have to buy back the loan from an investor should you default. As you can see, there is risk on both sides, but the biggest risk to you is the amount of the interest rate you are going to pay and the length of time you are going to have to pay it. If you have a prepayment penalty on your loan, for example, you are stuck in that interest rate until that prepayment penalty expires. If your credit and financial situation has improved by that point, you can then refinance into a more lucrative loan, but you will have to work hard to get to that point.
As you can see there are good and bad sides to both loans. The bottom line is that you have the ability to get a loan; it just depends on what you are looking for. If you are going to be in the home for a long time, you will have some decision making to do. The FHA loan will require you to pay MI for the life of that loan, which is obviously an added expense. Subprime loans do not have MI, so there is a price difference there, but if the interest rate you would get on a subprime loan is so high that it ends up to be more expensive to have that loan, you may want to opt to pay the MI on the FHA loan. Every case is different; it comes down to crunching the numbers to see which payment is the lowest for you for the longest length of time.