Getting a Mortgage Post-Bankruptcy

People get a home after bankruptcy

If the American dream is to own a home, conventional wisdom says about 800,000 dreams were shattered in 2016.

That’s how many bankruptcies were filed and a lot of people think that filing bankruptcy ruins any chance they’ll ever have to qualify a mortgage.

Think again. You could qualify for a mortgage as quickly as one year after your bankruptcy is discharged.

It depends on what type of bankruptcy you filed, what kind of loan you are pursuing, and how long a “waiting period” is involved, but if you get your financial house in order – specifically repair the damage to your credit score – you could walk into a new home not long after you walk out of bankruptcy court.

Why Is There a Waiting Period for Mortgages after Bankruptcy?

The first obstacle to owning a home after bankruptcy is dealing with the “waiting period” (also known as a “seasoning period”) required by lenders after bankruptcy.

Lenders want you to have time to restructure your finances and rebuild your credit score so they instituted waiting periods to allow you to demonstrate that you can handle mortgage payments.

For Chapter 7 bankruptcy, FHA and VA regulations require a two-year waiting period from the time of discharge (not the time of filing). Conventional loans require a four-year waiting period from the discharge date.

Getting a FHA or VA loan after Chapter 13 bankruptcy is a little more complicated. If you have consistently made verified payments for one year, you can apply for a FHA loan. You also must have a court trustee’s written approval and an explanation of your bankruptcy that demonstrates you had no other recourse. Otherwise, the waiting period is two years.

For a conventional loan after Chapter 13 bankruptcy, there is a 2-year waiting period after the bankruptcy was discharged. If your Chapter 13 case was dismissed, the waiting period is extended to four years.

What Are FHA Loans?

FHA loans are mortgages backed by the Federal Housing Authority. They are designed for consumers who have difficulty getting conventional loans. FHA loans have easier credit requirements and lower down payments.

Since the U.S. government backs the loans, lending institutions are more willing to offer them to applicants with poor credit scores. FHA loans permit down payments of just 3.5%.

A FICO score of 640 will usually qualify for an FHA loan, though applicants with lower scores might also qualify if they are willing to pay a higher interest rate.

What Are Conventional Loans?

Conventional loans are those originated by banks, credit unions and online lending sources and are the most common borrowing sources.

Conventional loans are not guaranteed by the government, but they do typically have the best interest rates and terms, resulting in lower monthly payments. They mostly come in the 30-year fixed-rate mortgage, which make up 87.3% of home loans in 2017.

You’ll need a decent credit score to get a conventional loan, but the mortgage has advantages over an FHA loan. The biggest is you won’ t have to pay private mortgage insurance (PMI) if your down payment is at least 20% of the amount borrowed.

PMI can add thousands of dollars to your mortgage. Once your equity in the house reaches 20% on a conventional loan, the PMI is dropped.

With an FHA loan, it never drops. You also have to pay a one-time up-front premium of 1.75% of the base amount of the loan.

That brings us to another wrinkle in the process.

Extenuating Circumstances

These are one-time events that caused a loss of income and were beyond a homeowner’s control that result in significant reduction of income or increase in financial obligations. They include things like job layoffs, medical emergencies and even divorces.

These extenuating circumstances could reduce the waiting period for a FHA loan to one year and for conventional loans to two years.

Extenuating circumstances do not apply if you blew $200,000 on a stock tip your brother –in-law gave you after he saw it on a late-night infomercial. That would fall under the “financial mismanagement” category.

Steps to Improve Your Credit Scores after Bankruptcy

We can’t overemphasize the importance of your credit score when applying for a mortgage. The better it is, the quicker you will be approved for a loan and the lower the interest rate you’ll qualify for. That can make a huge difference in your monthly bill.

The fastest way to improve a credit score is to make on-time payments on all your debts, (especially credit cards) and to keep the utilization rate on credit cards to below 30% of the credit limit.

These two factors – payment history and credit utilization rate – account for 65% of your credit score. Missed payments and overspending with your card are huge negatives that lower your score.

The other 35% of your credit score is divided between length of credit history (15%), credit mix (10%) and new credit (10%). It helps your score if you have a variety of credit (mortgage, car loans, student loans) and are able to balance your use of credit cards you have had for years and new ones obtained only because you need additional credit.

What a good credit score does is not just qualify you for a loan, but get you a better interest rate on that loan.

For instance, a $250,000 mortgage with a 3.5 interest rate would cost $1,122.61 a month. With a 4.5 interest rate, it would be $1,266.71. With a 30-year mortgage, the difference would add up to almost $52,000 by the time it’s paid off.

Chapter 13 bankruptcies stay on your credit report for seven years, and Chapter 7 bankruptcies stay for 10 years. The average credit score in July of 2017 for buyers using conventional loans was 754. It was just 686 for buyers using FHA loans.

Bankruptcies will knock 150 to 200 points off a score, but there are things consumers can do to lessen the impact.

You have to have a plan and know what you’re dealing with, so make a budget listing your expenses and income. Figure out ways to lessen the first category and increase the second.

The best way to raise your credit score is to pay your bills on time, since 35% of your FICO score is based on your credit history. Another 30% is based on the amount of debt owed. The best way to attack that is to stop using credit cards, or at least keep the amount you owe below 30% of your available balance.

Even that can be a budget killer due to interest rates on credit cards. The average rate in October of 2017 was 16.15%, according to CreditCards.com, and it was expected to rise as the Federal Reserve raised interest rates on federal funds.

If you have trouble kicking the credit card addiction, free credit counseling is available through many nonprofit organizations. Millions of people have gone a step further and enrolled in debt management programs. It can take three to five years and a lot of dedication, but the rewards are worth it. One of them is you’ll have a much easier time getting a mortgage.

So forget about conventional wisdom and whatever else you might have heard. Even after the nightmare of bankruptcy, your American dream can still come true.


Sources:

NA. (2017, February 21). FHA Loan Rules for Borrowers After Filing Bankruptcy. Retrieved from https://www.fha.com/fha_article?id=305

Lake, R. (2017, June 28) What to Know About Getting a Mortgage After Bankruptcy. Retrieved from https://smartasset.com/mortgage/getting-a-mortgage-after-bankruptcy

O’Neill, C. ND. What Is the Difference Between Chapter 7 and Chapter 13 Bankruptcy? Retrieved from https://www.nolo.com/legal-encyclopedia/what-is-the-difference-between-chapter-7-chapter-13-bankrutpcy.html

NA, (2016, June 9) How Long After Bankruptcy Can I Buy a House? Retrieved from https://aaacreditguide.com/buying-a-house-after-bankruptcy/

Huffman, M. (2017, October 20). Credit card interest rates poised to go higher. Retrieved from https://www.consumeraffairs.com/news/credit-card-interest-rates-poised-to-go-higher-102017.html

NA, ND. FHA Requirements for Mortgage Insurance. Retrieved from https://www.fha.com/fha_requirements_mortgage_insurance