Most of us aspire to buy our dream home, but if you’re new to the property market, then the whole process of obtaining a mortgage can seem quite daunting.
You probably have a reasonably good idea whether you look like a “good” borrower or not.
But the last few years have been tough for a lot of people and many previously financially stable people have suffered from job losses, business failure, or simply decided to go it alone as self-employed or a freelancer.
All these factors can make you look like a less attractive proposition for a mainstream lender and push you into the realms of “bad credit” or “sub-prime” mortgages.
But the good news is that all is not lost if you find yourself in this position. There are plenty of lenders willing to offer you a mortgage, even if you don’t meet the criteria for the “A-lenders” such as banks. These alternative “B-lenders” take a more flexible approach to assessing your borrowing prospects.
Understanding What Mortgage Lenders are Looking At
Understanding how mortgage lenders think will give you a good idea whether you fit their criteria. It might help you decide whether to postpone the home purchase and give yourself time to improve how you look to prospective lenders.
Whether a lender is an A-lender, such as the big 5 banks in Canada, or a B-lender such as a private mortgage company, they are all looking at two very basic questions when they assess a potential borrower:
- What is the risk to our capital if we lend to this applicant?
- What is the potential return if we lend to this borrower?
If you think of the lender as an investor who is balancing risk against reward, it’s a good starting point in understanding their decision process.
The following are the main measures mortgage lenders will look at:
- Credit score
This is a number attributed to every individual by 3 main credit reporting agencies. The higher your credit score the better your borrowing prospects.
- Income and employment history
How long you’ve been employed and whether you have held down jobs or had gaps in employment. If you’re self-employed they’ll look at your history of profits and whether these can be evidenced by tax assessments.
- Ability to repay (the “Stress Test”)
How much of your monthly income is taken up paying household costs (including your intended mortgage) and other debts. They will assume a certain increase in interest rates to see whether you would still be able to meet your monthly repayments.
- Amount of down payment
The more you can pay, the lower the risk to the lender as there is more equity in the property should you default.
20% as a down payment is considered low risk, but you can borrow up to 95% with mortgage default insurance, which is taken out by the lender to protect them should you default. The premium for this can be expensive and is added onto your mortgage but may still be worthwhile for you if the overall cost is justified.
- Type and value of the property
Lenders have different criteria for the type of property they will offer mortgages against. A-lenders for example are less interested in small, low value properties or mobile homes, particularly if the land isn’t owned by the borrower. B-lenders are often more flexible.
What is a Credit Score?
Every time you enter into a credit arrangement, and for the duration of the credit, the lender sends a monthly report to the 3 main credit reporting agencies, Equifax, TransUnion and Experian. In Canada the two main ones that are used by mortgage lenders are Equifax and TransUnion.
Credit arrangements consist of the obvious ones such as credit cards, personal loans, mortgages, finance for cars, boats, or anything else, but also some that aren’t so obvious such as cell phone contracts or “buy now pay later” deals with retailers.
It’s very helpful to check your credit score before you start looking for your dream home and the mortgage to buy it.
Credit scores range from 300 to 900. The following table gives you an idea of the range and what it means:
You are assigned a score based on several factors, some of which are given more importance in calculating the score.
It’s a big help when you look at your score to understand how these factors affect it, especially if you are at the low end and need to improve your score.
The measurements they all use and the importance of each in calculating your score are:
Payment history (35%)
This is the most important and shows whether you pay on time or have had any defaults or late payments.
Credit utilization (30%)
The amount of your available credit that you have utilized at any time. So, if credit cards are maxed out or above about 30% of their limit for any period, this will hit your credit score as it looks as though you rely heavily on credit.
Age of credit (15%)
The older your credit history, the better it is for your score (as long as the two factors above are in good order) as it gives a good insight into how you manage debt over a long time.
Every time somebody checks your credit score with a “hard” credit check it appears on your file and can affect your score.
A hard check is mainly carried out when you apply for new credit and, if your score is above average, will only have a small detrimental effect for 1 or 2 months. But if a number of inquiries appear in a short time frame, then it can have a worse affect as it looks as though you are desperate for credit.
In most provinces and territories of Canada a third party can’t carry out a hard credit check without your consent. The exceptions are Nova Scotia, PEI and Saskatchewan, where they only need to inform you.
“Soft” credit checks are generally not related to credit companies and don’t affect your score. Examples are when an employer checks your credit file, or you check your own.
Public records (10%)
If a previous or current creditor has referred you for collection of an unpaid or late debt payment, or if you have been pursued through the courts for payment, this will be on your credit record and will reduce your score.
If you’ve been bankrupt or subject to a consumer proposal within the last 7 years this will also be on your credit record.
Unpaid taxes, parking fines or child support may also appear on your credit report.
What Makes a Bad Credit Borrower?
There used to be quite a stigma attached to bad credit or sub-prime mortgages. But this is no longer the case and there are good reasons that a large number of Canadians are now turning to sub-prime mortgage lenders.
Federally regulated lenders such as the big 5 banks and credit unions have to comply with strict limitations on the risk they can take in their lending. This is designed to protect Canada’s financial system and prevent a repeat of the credit-crisis of the late 2000’s when banks took on huge amounts of sub-prime mortgages with little or no regulation.
However, you can be a good prospect for a mortgage, in terms of ability to pay and credit score, but still not qualify for a mortgage from the A-lenders.
If you’re self-employed, for example, your income that is assessed as taxable might be lower than the true picture because of your tax-deductible expenses. Or, if you are recently self-employed, you might not have sufficient years of assessments to satisfy the A-lenders, even though you have a very profitable business.
A lot of people have earnings which are less conventional than somebody with a steady salary. Freelancers, contract workers or people with a large part of their earnings made up from commissions, may not meet the A-lenders’ requirements, even though they have sufficient income to comfortably meet their payments.
Other reasons could be an unfortunate blemish on your credit history, such as bankruptcy or consumer proposal in the last 7 years. This could be due to unfortunate circumstances such as a job loss or divorce and, even if you have turned your finances around, A-lenders such as banks and credit unions are unlikely to lend to you for several years afterwards.
A low credit score is by far the biggest reason people are considered a bad credit borrower. A-lenders won’t normally consider applicants with a score below 680, especially if they have less than 20% as a down payment.
And a growing number of borrowers are now turning to B-lenders simply because they want to buy a property that doesn’t fit into A-lenders’ criteria.
The point is that there should be no stigma attached to being a “bad credit borrower”, it can be purely that you don’t fit into the narrow requirements of the prime mortgage lenders.
How To Get a Mortgage With a Bad Credit
As with any mortgage, being prepared before you start to approach lenders, or even start looking at properties, will put you in a better position.
Firstly, it’s important to understand that a bad credit mortgage will normally come with a higher interest rate between 1-3% (sometimes more) than you would pay with a mainstream lender. And usually there will be origination fees of 1-2% of the mortgage amount. This might not seem a lot but 2% of a $500,000 mortgage is $10,000!
Even if your credit score is between 600 and 680 there is the chance you may qualify for an A-lender mortgage if you can make a down payment of 20% or more. The lender’s risk is significantly reduced when you put more down yourself.
So, even if you look like a “bad credit” borrower, with a bigger down payment you might qualify for a mortgage with a mainstream bank, possibly with a slightly higher interest rate.
Although B-lenders can be more flexible than the main big banks or credit unions, they will still need documentation to verify your suitability as follows:
- Proof of identity
- Proof of Canadian residency
- Evidence of earnings
- Evidence of other assets
- Information on debts
- Bank statements
- Evidence of your down payment and its source
- Information on the property you wish to buy
Knowing your credit score before you start could save you a lot of time approaching the wrong lenders. And if it’s very low, below 580 for instance, then you might be better repairing your score before you go any further.
Paying down credit card balances and setting up payment plans for any problem debts is the first stage of improving your score. Meeting future payments on time will also help.
It’s not an overnight fix, but with discipline and a bit of time you could increase your score sufficiently to increase your chances of getting a mortgage at a lower interest rate.
Check your “Stress Test”
Prime lenders, who are federally regulated, have to carry out a stress test on your ability to pay.
This is based on your overall expenditure for household costs including the proposed mortgage payments and any other debt repayments. If the total is more than 42% of your before-tax income then your ability to meet payments, if interest rates increase, is deemed to be at high risk.
B-lenders aren’t compelled to carry out the same test, but they will look closely at it. So, it’s worth running the test on yourself before approaching lenders.
Once you’ve got an understanding of what you look like to a potential mortgage lender it’s time to start the search for one.
Finding the Right Lender
Mortgage Comparison Sites
Whether you’re in the realms of bad credit or prime borrowing, an excellent place to start is by checking out a mortgage comparison site.
You’ll be asked to enter some basic information on your situation and requirements and then presented with a list of lenders who might meet your needs, along with their rates, criteria, and other costs.
You could approach potential lenders directly but, if you need a bad credit mortgage it could save you a lot of time to use a broker as they’ll know which lenders to approach once they understand your situation and requirements.
Check their costs as many will receive a commission from the lender they place the mortgage with, but in the sub-prime market they may charge you a fee.
Getting a Mortgage with a Bad Credit Score : The Bottom Line
Being outside the “normal” is not unusual in this day and age. So, if you find yourself in that position and still want to buy that dream home, a bad credit mortgage could be your way forward.
A lot of Canadians are using sub-prime lenders to get into the housing market. And don’t forget, bad credit isn’t forever and there’s always the option to re-finance onto a cheaper mortgage further down the line.