You can qualify for a mortgage after bankruptcy or a similar financial calamity. Many people assume a bankruptcy appearing on a credit report for 10 years means they are disqualified from a home loan for 10 years. Wrong!
However, just because it is possible to qualify for a mortgage after bankruptcy does not mean doing so will be easy or require no work. Here are the key facts you need to know about qualifying for a mortgage after bankruptcy, and the three steps you can take to recover from bankruptcy.
4 Key Facts You Need to Know
Well-meaning but uninformed advice givers try to steer people away from bankruptcy by saying a bankruptcy makes qualifying for a loan impossible for 10 years, and will haunt them for the rest of their lives. Both statements are urban myths. If you hope to qualify for a home loan, here are the facts you need to know.
Fact No. 1: People qualify for a home loan 2 years after a chapter 7 or 13 discharge. There is no "lender punishment" for people who file for bankruptcy. According to FHA, VA, Fannie Mae, and Freddie Mac documents, the two-year waiting period is in place so they can see if the applicant pays their new debt obligations on time. In some cases, an otherwise qualified person need wait 12 months after their bankruptcy to obtain a loan.
Fact No. 2: Bankruptcy causes a severe decrease in a person's credit score. Expect your FICO score, the credit scoring tool used by most home loan lenders, to fall into the mid-500 range. As a result, plan to spend time rebuilding your credit so it meets the minimum credit score qualifications set by lenders.
Fact No. 3: Bankruptcy, especially a chapter 7 that wipes out personal debt, causes your debt-to-income (DTI) ratio to improve. Lenders see DTI as a key indicator of a borrower's ability to handle debt.
Fact No. 4: Obtaining new credit cards is not an issue after bankruptcy. Some lenders see the recently bankrupt as desirable loan candidates because people cannot qualify for chapter 7 for 8 years after a discharge, and 6 years after a chapter 13 (some exceptions apply). Most recently bankrupt people receive a flood of offers from banks who see this group as a lucrative market for high-interest and high-fee credit card offers.
Let's look at the three steps you need to recover from a bankruptcy:
- Rebuild your credit
- Put your financial house in order
- Understand the qualifications for FHA and other home loans
Step 1: Rebuild your Credit
Regardless of your starting FICO credit score, you should expect your post-bankruptcy FICO score to fall to 530 to 560. The time to full recovery will vary and depends on the effort you put into boosting your credit score and how high you want your score to be.
Start Rebuilding Your Credit History With A Secured Credit Card
A secured card is a tool to help you improve your credit score. Secured credit cards are simple: You deposit $200 to $5,000 with the credit card issuer. That amount becomes your line of credit. You use a secured credit card like you would any other credit card. Your payment history, on-time or delinquent, is reported to the credit reporting agencies — Equifax, Experian, and TransUnion — like any other credit card.
Beware predatory credit card issuers. Shop around to your local banks and credit unions to find the best deals in a secured credit card. Don't fall for the first offer arriving in your mailbox.
Diversify Your Credit With An Auto or Installment Loan
Each type of credit account or loan is called a trade line in the credit reporting business. Credit scores reward people with trade line diversity. Do not open multiple secured credit cards hoping to boost your score quickly. Instead, open one secured credit card, and then move on to a department store or oil company card, which will be viewed as separate trade lines.
Then consider buying a used car with a loan from your local bank or credit union. Avoid a buy-here-pay-here dealership because they often do not report any information to the credit reporting agencies. Alternatively, buy a single piece of furniture on an installment loan that is reported to the credit reporting agencies, and pay off the loan after six to nine months.
Make Your Payments On Time Every Time
The single largest factor that makes up a credit score is your payment behavior. The rule here is simple — make your payments on time every month. Consistent positive behavior is rewarded, and missed payments will punish your credit score.
Check Your Credit and Dispute Incorrect Information
Review the information appearing in your three credit reports to see if any incorrect information appears.
Dispute any errors by following the steps on the page just mentioned. Common errors include accounts still indicating a balance due after the bankruptcy, and someone else's accounts misapplied to you. If you see many mystery accounts in your report, this may be a sign of
identity theft.
Step 2: Put Your Financial House in Order
The intent of bankruptcy is to give a person a fresh start. This means if you had a recent successful bankruptcy discharge and are interested in qualifying for a mortgage, you should have no or a manageable amount of debt. If you keep your debt low, you will have a very attractive DTI when you apply for your mortgage.
Another key element in qualifying for a home loan is having a down payment. Pay yourself every month by depositing funds into a savings account. Save more than you need for a down payment so that you can show your lender you have cash reserves on hand.
Step 3: Understand the Qualifications
If you focus on improving your credit score to lift it from the mid-500s to the high 600s, keep your DTI low, and save for a down payment, you should qualify for a home loan. But, you will have to wait for 2 years from the date of your discharge to do so. Let us look at the qualifications for FHA- and VA-guaranteed loans. We also look at the standards Fannie Mae and Freddie Mac have in place today before each will consider investing in a recently bankrupt person's loan.
FHA’s Bankruptcy Rules
Generally, a person who has a chapter 7 bankruptcy discharge must wait for 24 months after the date of discharge before they can apply for a new FHA loan. During this span of time, the FHA requires the applicant to re-establish good credit, or chose not to incur new credit obligations. However, a person need not wait for 2 years.
After 12 months following a chapter 7 discharge, the FHA may approve an application if the borrower can show three facts:
- The bankruptcy was caused by extenuating circumstances beyond his or her control, such as:
- The death of the principal wage earner, or
- A serious long-term uninsured illness
- An ability to manage his or her personal finances in a responsibly manner.
- The events leading to the bankruptcy are not likely to recur.
A person who has a successful chapter 13 bankruptcy order must wait for 24 months after the date of discharge before they can apply. However, the FHA may approve an application after 12 months if the borrower can prove three things:
- One year of the pay-out period under the bankruptcy has elapsed,
- All required payments have been made on time, and
- The borrower received written permission from bankruptcy court to enter into the mortgage transaction.
If the Chapter 13 bankruptcy order occurred in the 12-to-24-month time span, expect the approval process to take longer than if the bankruptcy occurred more than two years ago.
VA’s Bankruptcy Rules
Like the, FHA, the Veterans Administration accepts applications from people who had a chapter 7 or 13 bankruptcy discharged more than 2 years ago. The VA will consider an application with a bankruptcy discharged 12 to 24 months ago under the following conditions:
- The borrower reestablished a satisfactory credit profile, and
- The bankruptcy was caused by circumstances beyond the applicant's control, such as unemployment, medical bills, and so on.
If the bankruptcy was discharged within the past 12 months, the VA believes it cannot determine if the borrower is a satisfactory credit risk.
If the borrower applies with a spouse jointly, the VA will look at the spouse's credit report for, among other factors, a recently discharged bankruptcy. The VA applies the same bankruptcy rules to spouses who apply for VA loans jointly.
Conformant and Non-Conformant Bankruptcy Rules
Mortgages today usually involve four parties:
- Borrower
- Originator. The originator could be a national bank or a local broker. The originator qualifies and funds the loan, and then sells it.
- Investor. Today, the investors in most home loans are Fannie Mae and Freddie Mac.
- Servicer. Collects monthly payments and manages escrow accounts for the investor. May be a national bank.
Conforming loans are sold to Fannie and Freddie. Non-conforming loans are sold to private-label mortgage securities investors.
Fannie Mae's Bankruptcy Rules
Fannie Mae requires a four-year waiting period after a chapter 7, measured from the discharge or dismissal date of the bankruptcy action. It will permit a two-year waiting period if extenuating circumstances can be documented.
Fannie Mae distinguishes between Chapter 13 bankruptcies that were dismissed and discharged. Fannie measures the waiting period required for chapter 13 bankruptcy actions as follows:
- Two years from the discharge date, or
- Four years from the dismissal date.
According to Fannie Mae, the shorter waiting period based on the discharge date recognizes that borrowers have already met a portion of the waiting period within the time needed for the successful completion of a chapter 13 plan and subsequent discharge. A borrower unable to complete the chapter 13 plan and received a dismissal will be held to a four-year waiting period.
Both Fannie and Freddie consider extenuating circumstance to be a nonrecurring or isolated circumstance, or set of circumstances that:
- Was beyond the Borrower's control,
- Significantly reduced income and/or increased expenses, and
- Rendered the Borrower unable to repay obligations as agreed, resulting in significant adverse or derogatory credit information.
Freddie Mac's Bankruptcy Rules
Freddie Mac's bankruptcy rules are very similar to Fannie Mae's, although Freddie documents its rules differently.
Private Label Mortgage Investors
Some members of Congress would like to see Fannie and Freddie back out of the market in favor of private-label securities investors, so non-conforming loans may become more important in the future.
Today, there are no uniform standards private-label mortgage investors follow for handling borrowers with recent bankruptcies. Some avoid them as too risky. Others embrace the perceived added risk. If you have a bankruptcy that is seasoned less than 12 months, your best chances for finding a home loan is to consult with a broker who has access to many funding sources. You should expect to pay more in fees or interest.
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Summary
Filing bankruptcy does not make it impossible for you to qualify for a mortgage. You can qualify for an FHA loan as soon as one year after a chapter 7 discharge, or with the bankruptcy court's permission if you have a chapter 13. Your first key strategy you should work on is boosting your credit score by making all of your payments on time. If your accounts were closed after discharge, then consider opening a secured credit card and bootstrapping yourself into more credit accounts that you pay on time.
Your second key strategy should be to develop a savings plan so that you have a down payment and cash reserve you can show the lender in your financial disclosures.
If your bankruptcy was less than 4 years ago, focus on finding an FHA loan, unless you can document extenuating circumstances. In that case, then your options open up to FHA, and loans conforming to Fannie and Freddie's requirements.
