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Buying a home in foreclosure is never a simple process. If you're looking to buy a foreclosure and have bad credit, you need to know that getting mortgage financing can be difficult, and a foreclosure purchase comes with significant challenges of its own. That said, it can be a great opportunity under the right circumstances. Here are a few tips for success in this tricky process.
How Does a Foreclosure Sale Work?
A home foreclosure occurs when a lender seizes a house for purposes of reselling it after a buyer fails to keep up with their mortgage payments. While it's bad news for the ousted borrower, foreclosure sales can provide major bargains for homebuyers. Lenders are typically eager to unload foreclosed properties at auction or to sell them directly to buyers, sometimes at prices below market value.
Buying a foreclosed home entails considerable risk, due to their being sold in as-is condition: Foreclosed homes may have been unoccupied for months prior to resale and may be subject to neglect or even vandalism by evicted former occupants. For this reason and more, it's usually best to work with a mortgage broker or real estate agent who's well-versed in handling foreclosed property sales.
Buying a Foreclosed Home With Bad Credit
Even under the best of circumstances, the risk inherent in foreclosed properties can make it difficult to buy one with traditional mortgage financing. It can be even harder if your credit is less than ideal, but that doesn't mean it isn't worth a try.
If you're a first-time homebuyer planning to use your purchase as your primary residence and your credit score is 500 or better, it's worth investigating a Federal Housing Administration mortgage, better known as an FHA loan. These loans offer generous borrowing terms but also come with fairly strict qualification requirements: Some foreclosed properties are ineligible for purchase with FHA loans, and you'll need a down payment of at least 20% of the property's appraised value if your credit score ranges between 500 and 579. If your credit score is 580 or better, a 10% down payment is required.
If mortgage financing proves unfeasible, there are a couple alternatives to consider:
- Cash payment: Paying cash is the preferred method of many real estate investors, so lenders are comfortable with cash purchases. In markets where foreclosure sales are soft, lenders may even negotiate a lower sale price in exchange for a cash sale. Of course, access to sufficient cash to buy even a bargain-priced foreclosed home outright is a tall order for many potential buyers.
- Hard-cash lenders: If you own real estate or other property worth at least as much as the purchase price on your chosen foreclosure, a hard-cash loan may be an option. These loans, which use your property as collateral, are highly risky: They typically come with high interest rates (25% is not unusual) and short repayment periods (five years or less). Not only that, failure to pay off a hard-cash loan could result in the loss of the property used to secure it.
Hard-cash lenders typically do not check credit scores, however, and their approval process is often quicker than that of a mortgage loan. So if you're buying a foreclosure as an investment and are confident you can get it to generate sufficient cash flow in time to cover the loan, a hard-cash loan could work for you even if your credit is in bad shape.
Improve Your Score Before Buying a Home
Resourcefulness may enable you to swing a foreclosure purchase with bad credit, but there's no doubt you'd have better options—including the potential for borrowing from multiple sources at more competitive interest rates—if your credit score were in good shape.
That's why, whether you're buying a foreclosure, purchasing from an existing owner or buying a brand-new home from a builder, it's a good idea to go into the process with a clear understanding of your credit standing. Checking your credit reports and credit score before you apply for a mortgage or other financing is a great way to start.
If it's lower than you'd like, you can take action to improve your credit score. Depending on your score and financial situation, you may be able to bring about a significant score increase in one year or less by adopting credit habits that promote score improvement.
Credit scoring firm FICO says the following factors matter most in its score calculations:
- Timely payments: Paying bills on time helps your credit score, and late or missed payments are the single biggest factor that can lower it. Payment history accounts for as much as 35% of your FICO® Score☉ .
- Credit usage: Experts recommend using no more than 30% of your total credit card borrowing limit to avoid lowering credit scores. Also known as your credit utilization ratio, your credit usage rate is responsible for 30% of your FICO® Score.
- Length of credit history: Your FICO® Score tends to increase over time. You can't accelerate the process if you're a new credit user but establishing a record of timely payments can help you build up your scores as your credit history increases. Length of credit history accounts for up to 15% of your FICO® Score.
- Credit mix: Credit scores take account of all your debt and the different types of credit you use. The FICO® Score tends to favor a mixture of loan types, including both installment credit (loans with fixed monthly payments) and revolving credit (such as credit cards, with variable payments and the ability to carry a balance). Credit mix can influence up to 10% of your FICO® Score.
- Recent credit activity: Applying for loans and credit cards triggers hard inquiries, which keep track of when lenders check your credit score for use in lending decisions. Hard inquiries typically lower your credit score by a few points, but as long as you continue to pay your bills on time, scores usually rebound within a few months. (Checking your own credit triggers a soft inquiry, which does not affect your credit score.) Recent credit activity contributes about 10% of your FICO® Score.
- Derogatory information: Certain credit report entries can severely lower credit scores for extended periods of time, depending on the nature of the information. The negative impact of these entries diminishes over time, but initially at least, they can drive down your credit score and keep it down for months or even years. Because these entries are not found in all credit reports, FICO doesn't assign them percentage weights.
While it's possible to purchase a foreclosed home when you have bad credit, taking steps to improve your credit scores may prove less difficult—and more practical in the long term.