Bad Credit Mortgage Alternatives

Dear New Frugal You,

Several years ago, during the middle of a nasty divorce, I was told that I should file for bankruptcy. I did get the divorce, but never did file for bankruptcy. I did quit paying those debts and as far as I know they've all been written off and no one has tried to collect them in years. For the past five years I've kept up with all of my new bills. Here's my problem. Due to the recession, rents have been going up. I could make mortgage payments for less than I'm paying in rent. But I doubt that I can qualify for a mortgage. Is there anything that I can do?

- Bridget

Dear Bridget,

Like many others, you've discovered that the recession has affected not only home sales, but also the price of rentals. And, for many renters, the cost of renting is greater than the cost of buying.

And again, like many others, your credit history could make it hard to qualify for financing, especially when banks are being cautious about potential borrowers. Let's see what we can do to increase your odds of buying your own home.

Begin by checking your credit report. If you haven't done so recently -- say, within the past three months -- you should check your credit at AnnualCreditReport.com, the federally mandated site that gives you free access to your three major credit reports once a year. Contest any inaccuracies.

Next, check your FICO credit score -- the three-digit number derived from your credit reports. You may even qualify for a free credit score; if not, go to MyFICO.com and pay a nominal fee to pull your score. Knowing your score will help you determine if you're likely to qualify for a mortgage. You'll probably need a score of 725 or greater to get the best mortgage terms.

Do what you can to improve your score. Don't let a low score discourage you. Actually, you may be pleasantly surprised, since you're already taking the most important step by paying your bills in a timely manner.

Generally, damaging credit info stays on your report for seven years -- or 10 years for that bankruptcy you didn't declare. If you've been paying your bills on time for five years, that means that much of your bad info should drop off in a few years.

A warning to consider: Do not start to repay those old debts! If you've ignored them for five years, they will soon disappear from your credit report, and so they'll no longer be figured into your score. But the seven-year period starts with the last activity on the account. So any payments would "re-age" the debt and restart the clock at zero. That keeps the account on your score for seven more years, and keeps you legally liable for the debt until the statute of limitations in your state runs out again.

Don't fall for ads saying that they can erase bad credit info. If the information in your credit report is accurate, there's nothing you can do to remove it until the seven years have passed.

Do attempt to get preapproved for a mortgage. If your score is marginal, stress the past few years when you've been a good credit risk. There's a good chance that you'll be turned down for a mortgage. Banks are being very cautious right now.

If you can't get a standard mortgage, don't let that stop you. There are several mortgage alternatives for people with bad credit:

Find a landlord who is willing to do a lease with an option to buy. If you do an option to buy, you will want to get an attorney. While the concept of renting to own is simple, there's a whole bunch of legal potholes that a lawyer can help you avoid.
Private lenders may be more willing to give you credit, especially since they can hear how you've turned the corner and they're familiar with the property that would secure the mortgage. They might also like the fact that you'll probably be paying them a higher rate of interest on the mortgage than they can get in many income-producing investments today.
Another possiblity would be to find a seller who is willing to take back the mortgage -- which means the seller would be your lender. Again, by dealing with a private lender, you have a better chance of finding someone willing to work with you.
Check in with programs for low-income homebuyers. Most assistance programs are run locally, so speak with you community social service agencies to find out what's available. Some, such as Habitat for Humanity, require a certain amount of sweat equity, so you and family members would be expected to work on the house as it's being constructed. You may be able to apply that sweat equity concept to the lease-with-option or seller-financed properties. After all, a rundown property is harder to sell and harder to get financing for. So an owner trying to sell a property that requires some work may be more willing to give you a mortgage -- if you're willing to do the work.

You may find that you just need to struggle through the higher rent for a couple of years while you work on raising your credit score. If that's the case, see if you can't talk your landlord into a two-year lease. That will lock in your rent for a longer period.

What can the rest of us learn from your experience? First, that there are advantages to not declaring bankruptcy. One advantage is that bad news comes off your credit report three years sooner. Secondly, there's more than one way to find financing for a home or condo purchase. Many sellers are having trouble finding buyers who qualify for a mortgage. By offering them a creative solution, you're helping them sell their property.

Finally, whether you've had financial problems in the past or not, it's wise to monitor your credit score and check for errors, especially if you're about to borrow for a major purchase.