A conscientious and responsible young man would like to buy his first house.
Let’s assume that he's always been wary about incurring any kind of debt–he’s never applied for any credit cards; paid cash for his car; he doesn’t have a student loan, and he only buys what he can afford from his monthly salary.
In most circles, this young man would be lauded for being exceptionally smart about his money management practices and for wisely avoiding the trap of debt. However, his lack of verifiable credit is going to work against him when it comes to buying his first house.
Why? Because the first thing most lenders look at when you apply for a mortgage loan is your credit history.
Most people have the usual forms of credit, such as auto loans, credit cards, or a current mortgage, which forms a record of how they manage their debt and is the basis for their overall credit score.
If you have no credit history (like our fictional young friend), then it can be difficult to find a mortgage lender willing to work with you.
However, it’s not impossible. There are specific steps you can take to establish “non-traditional credit sources”, which some lenders will accept in lieu of a more traditional credit history.
In addition, there is a specific type of government loan that is a mortgage option for borrowers who fit into this “low/no credit” category.
Non-traditional Credit Sources
It’s possible to secure a home mortgage without a credit history, but it’s not as easy as it would be if you'd developed some other form of credit over several years.
The key is to establish a payment history by convincing other non-traditional credit sources to report to one of the three major credit reporting agencies on your behalf.
Non-traditional credit sources include such items as rent payments, phone bills, utility bills, or any other regular payments that are routinely made, in order to establish a payment history.
For instance, Experian (one of the three major credit-reporting agencies) accepts rental payment history information as proof of credit history, but your landlord must be registered in their system in order to report your payment information.
Although some larger multi-family apartment complexes are already set up to report payment history to the credit-reporting agencies, private landlords of single units or smaller properties might not realize they can offer this service to their tenants.
Therefore, it will be up to you to convince your landlord to do what’s necessary to report your payment history to the credit-reporting agencies.
If your landlord is willing, payment reporting can be done online via third-party processors such as PayYourRent, ClearNow, and RentTrack. But there is a nominal fee for landlords to report their tenants’ payments, so you will have to make your landlord aware of that cost.
Utility payments and cell phone bills are also acceptable to Experian, and making timely payments for at least six months or more will go a good ways towards building a positive credit score.
Paying your rent and utility bills on time demonstrates credit responsibility and is a good indication of how well you might manage other debts.
On the other hand, any late rent or bill payments will also be reported and will work against you, so you must make sure to pay your bills on time.
Consider a Government-Backed Loan
FHA Loan
If you don’t have a traditional credit history, you might want to consider a loan backed by the Federal Housing Administration (FHA).
The FHA specifically states on their website that, “The lack of a credit history, or the borrower’s decision to not use credit, may not be used as the basis for rejecting the loan application."
Though your application for an FHA loan cannot be rejected because of a lack of credit, there are still requirements related to your payment history that must be met. These include:
- No delinquency on rental payments.
- No more than one 30-day delinquency to other creditors, such as utility or car insurance payments.
- No collection accounts other than medical-related incidents.
- In addition, your total debt (which includes your new proposed mortgage payment) cannot exceed more than 43% of your income. And at closing, you must have at least one month’s worth of cash reserves in your bank account after your down payment has been made.
Another benefit of an FHA loan is that typical down payment amounts can be as low as 3.5 percent (most conventional loans require 20%). You also have the option of rolling closing costs into your loan balance.
There can also be some disadvantages to applying for an FHA loan. For one thing, there's more paperwork involved in the process, and approval takes considerably longer. Another issue is that FHA loans cannot be used to buy investment properties, only for primary residences.
Mortgage insurance premiums must be paid on an FHA loan, which can be an issue for some borrowers.
Besides the initial 1.75 percent fee when the loan is originated, part of your monthly payment is an additional ongoing mortgage insurance premium, which must be paid until your balance reaches 78 percent of the purchase price.
A final aspect of FHA loans to keep in mind is that there are minimum standards your house must meet. If you intended to buy a distressed property, your loan might not be approved, or at least not until necessary repairs are made.
VA Loan
There are other more specialized government-backed options as well. For one, if you are or have been a member of the armed forces, you could qualify for a VA loan.
VA loans, created in 1944 to help military personnel purchase their own homes, are guaranteed by the U.S. Department of Veteran Affairs. Private lenders issue them, yet their requirements are much more flexible than those of conventional loans.
Additionally, unlike a traditional mortgage, VA loans do not require a down payment or mortgage insurance.
There are important things to remember if considering a VA loan:
- Although the Veterans Affair Administration does not require a specific credit score or extensive credit history to qualify for the loans, the private lenders who fund the loans could. Because of the government guarantee, however, many private lenders will be more flexible in their requirements, with come VA lenders accepting FICO credit scores that range from 560 to 620.
- The VA has minimum requirements for the property that include livability and safety, and so these loans cannot be used for homes that need extensive repairs.
- VA loans do not have a maximum amount, yet the VA limits its guaranty to $424,100 without a down payment in most states.
- As is the case with other loans, the VA requires you to have an income-to-debt ratio that shows you can meet the financial obligations of a mortgage. That means that you must have a consistent source of income – preferably from a job where you work at least 30 hours a week- and that is expected to continue for the foreseeable future.
USDA Loan
Another government-backed option is the USDA loan.
Also known as Section 502 Single-Family Housing Guaranteed Loan Program, this is a special type of program designed to bolster home ownership in eligible rural areas and is backed by the U.S. Department of Agriculture.
Much like the VA loan, the USDA loan is a special type of loan that does not require a down payment. It is aimed at low- to moderate- income borrowers and requires that they fit specific income guidelines.
The government guarantees 90% of the loan note value, to offset the risk this might present for lenders. Once approved, borrowers can use the loan to build, rehabilitate, improve or even relocate their home.
Aside from the single-family housing program, there are three other types of USDA loans: single family direct homeownership, rural repair, and rehabilitation loan or grant, and the mutual self-help loan.
To be eligible for a USDA loan, you must have:
- Dependable income for approximately two years
- Agreed to use the property as your primary dwelling
- No late payments or collections for at least a year before applying
- An acceptable income-to-debt ratio (this can vary from lender to lender)
- Income that does not surpass 115% of the area median income
- A minimum credit score of 640 for streamlined approval. Applicants with lower credit scores will still be considered on a case-by-case basis using a manual underwriting process.
In Summary
By some estimates, there are more than 5 million people nationwide who are lacking a traditional credit history, so you’re not alone!
Don't let your lack of a credit history discourage you from purchasing a home if that’s your goal.
Take the necessary steps now to set yourself up so that you will be able to qualify for a future home loan.
If you’re currently renting, ask your landlord and other service providers to report your payments to a processor that is associated with the major credit reporting agencies.
As long as you make all your payments in a timely manner, you’ll have a worthy credit score when the time is right for you to buy a home.