As with any major purchase that requires a line of credit, the process of buying a home starts with your credit score; the better it is, the better your chances of being approved for a loan. But what happens if you have little or no credit history, as is the case with many first-time homebuyers?
Fortunately, all hope is not lost if you don’t have a credit history or are just starting to establish a credit history, also known as having thin credit.
Understanding why established credit is advantageous
While some financial gurus will tell you to live debt-free with no credit cards or car loans, doing so can actually hurt your ability to apply for a mortgage and buy a home, according to a May 2015 article on Bankrate.com by contributor Marcie Geffner.
Homebuying typically requires credit, as a 2014 poll shows only 5 percent of Americans were able to purchase their home outright, Geffner reports. This means establishing a credit history and a good score is necessary and important if you are planning to buy a home in your lifetime.
According to a November 2016 article in The Mortgage Reports by contributor Erik Sherman, a credit report is an account of all the lines of credit and loans under the person’s ownership during his or her lifetime, which is compiled by several credit bureaus. These companies receive the borrower’s credit history by the creditor company on a regular basis and use this data to calculate a credit score.
Furthermore, credit scores are determined by a number of factors, the single largest of which is payment history, including timeliness. Your score reflects your calculated ability to pay back borrowed funds, with a high score indicating a high chance of your making your payments.
“Call it the unintended consequence of debt-free living: with no visible evidence that you’ve managed credit accounts in the past, mortgage lenders become (rightfully) nervous about your ability to repay on a loan—there’s no history for them to go on,” says Sherman.
Alternative options for purchasing a home
Geffner suggests two options for purchasing a home if you lack a sufficient credit history.
The first is to create an alternate credit history using other financial reports, like rent checks, utility bills and insurance premiums. However, this process can become time consuming and not all lenders have the resources to do it for you. Additionally, Geffner warns that you could end with a less-than-favorable credit score if the data dates back only a few years, which will mean paying a higher interest rate than if you had a good credit score with a traditional history.
The second option is to open a credit card, make a purchase with a modestly large charge and make at least the minimum payment for six months before applying for a mortgage. Even half a year of established credit history is better than none, and at six months you’re eligible to receive a calculated FICO score, which will greatly improve your chances of being approved for a loan.
Be wary of opening a new line of credit if you don’t have the time to establish a solid payment history before applying for a mortgage, Sherman warns.
Opening new lines of credit, like credit cards or a car loan, is not optimal for short-term credit history and could actually do more harm than good in trying to establish credit. This is because credit bureaus calculate new lines of credit as a negative, because they’re considered debt in a consumer’s purchasing history.
Instead, Sherman advises that first-time homebuyers or others with little or no credit look to Federal Housing Administration (FHA)-backed mortgages. FHA mortgages are meant for those with little or no credit, and are offered by almost every major lender.
Rather than turn away borrowers based solely on credit history, the FHA mortgage looks at the entire application and reported data. Furthermore, this type of loan allows for a 3.5 percent down payment instead of the typical 10 percent to 20 percent, so potential homeowners are more likely to have enough money saved to qualify.
In the end, buying a home is not impossible without credit history, so long as you know your options.