Obtaining a mortgage is becoming increasingly difficult due to the struggling economy and stricter mortgage lending rules. Four times in the past four years, the government has tightened mortgage insurance rules in order to cool the Canadian housing market, and lenders therefore assess the stakes involved with loaning prospective buyers money even more closely.
Your credit history plays a significant role when you apply for a mortgage. If you weren’t able to pay your debts, you might have a hard time obtaining a mortgage in Canada, as lenders might consider you too risky. However, this doesn't mean it's impossible to get a mortgage if you have a bad credit report. You don't necessarily need to put down 20 per cent upfront and have a decent credit history, but you do have to be prepared and recognize that your options will be limited and you’ll have to pay more.
What's Considered "Bad Credit"?
Your credit score indicates the likelihood that you'll repay your debts. It's expressed as a number ranging from 300 to 900 based on your credit accounts and their history. The higher your number, the higher the score, as well as your creditworthiness. As Maura Drew-Lytle from the Canadian Bankers Association informed us,
When lenders are assessing a loan application, they look at a number of factors. Some of the things that could impact a customer's ability to get a loan include a poor credit rating, a past history of not paying bills or not paying them on time, questions about the ability of the customer to pay back the loan (because too much of their income is going to service other debt, for example), too much debt or a recent bankruptcy.
Credit scores that are lower than 620 are considered bad by the majority of lenders. If your score is between 620 and 650, you can still acquire a prime mortgage with a decent interest rate, but if your score falls below 620, you might be considered too risky. Other aspects that have an impact on your creditworthiness and can make you a risky borrower include two or more delinquencies of one month on a mortgage within the last year, one delinquency of two months within the last year, a charge-off or foreclosure in the past two years, bankruptcy in the past two years, a debt-to-income ratio higher than 50 per cent, or an inability to cover your monthly family living expenses.
On the other hand, your overall creditworthiness is determined by numerous factors, and therefore you can get a conventional mortgage even if your credit score is lower than 620. The only way to make sure you don't qualify for a prime interest loan is to apply for one. Even if you have some issues with your credit score, you can explain these negative implications in your application. Maura Drew-Lytle remarked,
Banks look at each mortgage application on a case-by-case basis, so it would depend on an individual's financial situation, but a poor credit history could mean that an individual would either not qualify for a mortgage or would get a mortgage at a higher interest rate, which helps mitigate the risk to the lender.
Keep in mind that the lender wants to find out whether you're creditworthy, and sometimes a reasonable explanation can prove that lending you money isn't as big a risk as the numbers suggest. A lender may have a different opinion on your credit history if you explain that you went through a divorce or had medical problems that lowered your income. Plus, in case of past foreclosures or bankruptcies, you can point out that now you have a higher income and a better financial situation and you can assure the lender that you have sufficient funds and won't default on your loan.
A "Bad Credit" Mortgage
Borrowers who have a bad credit rating and pose a big risk to the lender usually don't qualify for a conventional mortgage but can get a sub-prime mortgage. A sub-prime mortgage has higher interest rates, which compensate for the high risk the lenders are taking. The amount of interest you'll have to pay with a sub-prime mortgage is determined according to your credit score. This means the better your credit score, the lower your interest rate. Patricia White, executive director of Credit Counselling Canada, told us,
The negative aspect of credit comes from not handling credit properly. For example, if you are exceeding your credit limit or if you have been missing payments, then you will have a lower credit score. Lower credit scores impact the interest that you might be charged, so it's important to manage your credit wisely by paying off balances as soon as possible or at least paying the minimum monthly payment on time and keeping your credit usage well below the authorized limit.
Plus, when determining interest rates of sub-prime loans, lenders take into consideration types of delinquencies that are recorded on the borrower’s credit report as well as the amount of the down payment.
It's important to note that sub-prime loans often include two types of penalties: a pre-payment and a balloon payment penalty. A pre-payment penalty is a penalty that a borrower has to pay if he or she pays off the loan before the end of the term. This can happen in a situation when a homebuyer sells a home or wants to refinance it. On the other hand, a balloon payment penalty means that the borrower has to pay off the entire balance in a single payment after a specified period expired. It's usually five years, and if the borrower fails to pay the whole sum, he or she has to refinance, sell, or lose the house.
There are several different types of sub-prime mortgages, including short-term forms of adjustable-rate mortgages (3/27, 2/28) as well as fixed-rate, floating-rate, or variable-rate mortgages. A 3/27 adjustable mortgage has a three-year fixed interest rate period followed by floating interest rate based on an index with a margin. A 2/28 adjustable mortgage is similar, but with a two-year fixed interest rate period. The main risk with these two mortgage solutions is that the interest rate rises significantly after the fixed period, increasing the borrower’ s payments as well.
Typically, a sub-prime mortgage should provide a short-term financing solution for borrowers who are experiencing financial turbulence. The best way is to choose a term that's not too long but at the same time provides you enough space to rehabilitate your credit so that you can refinance into a conventional mortgage with all its benefits, including a better rate. Having a longer term in a sub-prime mortgage is risky, as you can end up deeper in debt.
The major lenders in Canada don't offer sub-prime mortgages, and the Canada Mortgage and Housing Corporation doesn't insure them. In 2012, sub-prime mortgages comprised less than 5 per cent of the market, according to The Globe and Mail. Unlike American banks, Canadian banks, trust companies, and credit unions are more conservative regarding risk management practices. You will therefore have to apply for a mortgage from an uninsured lender, such as Equitable Trust or Home Trust, or try a private lender.
Applying for a Mortgage with Bad Credit
Applying for a mortgage with bad credit is a difficult and risky process, so you should always contact a mortgage broker and discuss your options. First of all, you need to review your credit report and make sure that it's up-to-date and accurate. Checking the accuracy of your credit report is very important, as the Canada Mortgage and Housing Corporation points out:
Because errors and omissions on credit reports do occur, it is a good idea to check your file from time to time. Anyone can request a copy of their credit file from the credit bureaus via mail or fax… If you find an error or discover that favorable credit information is missing, contact all the credit bureaus and have it corrected to ensure your credit history is accurately represented to creditors and lenders. Your are going to need proof, so be ready to provide statements or receipts.
You also need to gather all the documents you can use when explaining the reasons for your past financial difficulties as well as evidence of your otherwise good payment history. You can add documents such as rent payments, electricity and utility bills, or cell phone bills. Make sure you discuss all the documents with your mortgage broker and, if possible, provide a logical explanation for your poor credit score. Plus, you can improve your creditworthiness by having your family members or friends co-sign the loan. A person who co-signs a mortgage loan basically promises to pay off the loan in the event the borrower is unable to pay off the loan. In this case, you can get a prime mortgage loan with a favourable interest rate.