Getting a Mortgage After Bankruptcy

Bankruptcy doesn’t have to put an end to your dream of owning a home – it could happen as early as a year after bankruptcy discharge.

The key is to  take positive steps with your credit and get back your financial footing. There are a lot of balls to juggle when getting a mortgage after bankruptcy. Besides the variety of mortgages available, all with their own rules, there are also different types of bankruptcy. Both factor in to how long you have to wait before you can apply for a mortgage after bankruptcy is discharged.

Another factor is you – what led to your bankruptcy, how you have handled your finances since and how you plan to handle them going forward.

Whatever the length of the waiting period, use that time to do the work that will help you qualify.

A mortgage after bankruptcy can mean higher interest rates and a more expensive mortgage. Improving your credit score after bankruptcy will help counter that.

Why Is There a Waiting Period for Mortgages After Bankruptcy?

A bankruptcy, whatever the reason, tells a lender the person filing had trouble paying bills. Lenders want to make sure that someone who had to take that drastic financial step is now a good risk. A mortgage is a lot of money that takes a long time to pay back. Lenders aren’t punishing mortgage applicants for filing bankruptcy, they just want to make sure they’re a good financial bet.

The first obstacle to owning a home after bankruptcy is dealing with the waiting period (also called a seasoning period). Use that time well restructuring your finances and rebuilding your credit. It shows lenders you can make payments on time and live up to your end of the deal.

The waiting period as a chance to prove that bankruptcy doesn’t define you, but that you’re someone who’s taken a bad financial situation and turned it around. You’re committed to managing a budget and making payments.

There are three kinds of personal bankruptcy, Chapter 7 and Chapter 13 make up 99.9% of bankruptcies. Chapter 11 is sometimes, though rarely, used by individuals. Waiting periods differ for each one.

Waiting Period after Chapter 7 Bankruptcy

Those filing Chapter 7 must sell their assets to pay off unsecured debt, like credit card debt, medical bills and personal loans.

With Chapter 7 bankruptcy, FHA and VA mortgage regulations require a two-year waiting period from the time of bankruptcy discharge. That’s the point the court released you from your debts, not the time you filed. A Chapter 7 discharge usually takes 6-8 months after filing.

USDA loans require a three-year waiting period and conventional loans require a four-year waiting period.

A Chapter 7 bankruptcy stays on your credit report for 10 years.

Chapter 13 Bankruptcy

Getting an FHA, VA or USDA loan after Chapter 13 bankruptcy is more complicated than after a Chapter 7.  A Chapter 13 bankruptcy also takes longer to discharge. Chapter 13 allows you to make payments to some or all of your creditors over a period of three to five years. Your remaining debt is discharged once those payments are made. It stays on your credit report for seven years.

The waiting period for getting an FHA mortgage after Chapter 13 bankruptcy is two years. It requires permission from the bankruptcy trustee – the person who oversees the creditor repayment plan – as well as proof of on-time payments on the bankruptcy plan.

With a USDA loan, the waiting period is 12 months of successful plan payments.

There is a two-year waiting period for a conventional loan. If the Chapter 13 case is dismissed – meaning the bankruptcy plan wasn’t followed — the waiting period is four years.

All of these, like Chapter 7 bankruptcy, can be shorter if there are extenuating circumstances that led to the bankruptcy.

Chapter 11 Bankruptcy

While it’s rare for an individual to file Chapter 11 bankruptcy, which is a reorganization plan usually used by businesses, it is occasionally an option for those who make more money than what’s allowed with Chapter 7,  but have too much debt to qualify for Chapter 13.

Someone who files for Chapter 11 bankruptcy can apply for a mortgage any time after the bankruptcy is discharged. The bankruptcy process is expensive and involved, though, which may outweigh the shorter waiting period.

Loan Cost Comparison

The interest rates for a mortgage loan after bankruptcy vary, depending on the loan as well as the borrower’s credit score. A bankruptcy can knock as much as 200 points off your credit score.

Interest rates go up and down, depending on economic circumstances. For instance, in 2020 and 2021, the U.S. Federal Reserve kept interest rates historically low. While rates fluctuate, the gap between the rate for a borrower with a high credit score and one with a low credit score stays about the same.

This chart, showing rates from 2021, compares interest rates for different types of loans and how they vary with credit scores:

What Are FHA Loans?

FHA loans are mortgages backed by the Federal Housing Authority, designed for people who may have trouble getting a conventional loan because of a poor credit history or income. 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, although the lower your credit score, the harder it can be to find a lender.

A borrower with a FICO score of 580 can qualify for an FHA mortgage with a down payment of 3.5% and someone with a 10% down payment can qualify with a 500 score. The lower the score, the higher the interest rate and the harder it may be to find a lender. While applying with a credit score less than 600 is possible, less than 2% of FHA mortgage borrowers had a credit score that low early in 2021.

The waiting period to get an FHA loan after a bankruptcy without extenuating circumstances is:

Chapter 7 — Two years from the time of discharge.

Chapter 13 — Two years if plan payments have been made on time and the trustee of the bankruptcy gives an OK.

Some banks have a three-year waiting period, which overrules the FHA’s waiting period.

What Are Conventional Loans?

Conventional loans are those originated by banks, credit unions and online lending sources.

They are not guaranteed by the government, but they typically have the best interest rates and terms, which means lower monthly payments. The most common type of conventional mortgage is 30-year fixed-rate, which accounted for 79% of mortgages between  2019 and  2021, according to ICE Mortgage Technology.

Conventional loans require a credit score of 620 or higher. The higher the score, the better the terms. One of the biggest advantages is that a down payment of 20% means you don’t have to pay private mortgage insurance, which can add thousands to a mortgage.

Even if you don’t put down 20% at the closing, once the equity in the house reaches 20%, the PMI is dropped. With an FHA loan, it never drops, and you have to pay a one-time up-front premium of 1.75% of the base amount of the loan.

The waiting period for a conventional loan after bankruptcy is:

• Chapter 7 – Four years after discharge date
• Chapter 13 – Two years. If the case is dismissed, which happens when the person filing for bankruptcy doesn’t follow the plan, it’s four years.

What Are VA Loans?

The VA loan program, administered by the U.S. Department of Veterans Affairs, offers low-cost loans to veterans and active military personnel. Qualified borrowers aren’t required to make down payments, some of the closing costs are forgiven and borrowers don’t have to pay mortgage insurance.

There are several requirements for those who have gone through a bankruptcy if they want to get a VA loan.

Chapter 7

• No late payments since the bankruptcy filing;
• No derogatory credit (collections) since the bankruptcy;
• A minimum median credit score of 530-640 (based on where the borrower lives);
• Two year waiting period after discharge.

Chapter 13

• A minimum 12 months wait from bankruptcy initiation date;
• A satisfactory performance of the bankruptcy repayment plan;
• No late payments after the date of the 341 (meeting of creditors and bankruptcy trustee);
• The trustee or court must approve any new debt if the borrower is still in bankruptcy;
• The borrower must have no derogatory credit (collections) from the date of filing for bankruptcy;
• The borrower must have a minimum credit score of 530-640 (based on where they live and lender guidelines).

What Are USDA Loans?

USDA loans are backed by the U.S. Department of Agriculture for low-and-middle-income borrowers who may not qualify for a conventional loan. The mortgages have low down payments and no closing costs for those who buy a home in a qualifying rural area, which includes about 97% of the U.S. A borrower’s income can’t exceed 115% of the median income for the area. Mortgages are 30-year, fixed-rate.

While the USDA doesn’t set a minimum credit score, most lenders who process USDA loans require a minimum of 640.

Waiting period for applicants who have filed for bankruptcy:

• Chapter 7 – Eligible three years after discharge.
• Chapter 13 – Eligible after 12 months if they’ve stuck to their plan payments.

How Foreclosure Prolongs a Mortgage Waiting Period

Sometimes a bankruptcy isn’t the only financial setback a potential mortgage borrower is dealing with. The bankruptcy may have been preceded by foreclosure on a mortgage.

Having both a foreclosure and bankruptcy may prolong the mortgage process more than just a bankruptcy, and may add other requirements.

The following chart shows the length of time after a foreclosure a potential borrower may apply for a loan:

Extenuating Circumstances

A bankruptcy may result from something you never saw coming, a one-time event that caused a big loss of income and/or increase in financial obligations and was beyond your control. Many people during the COVID-19 pandemic found themselves in a dire financial situation they never would have envisioned beforehand. Job layoffs, medical emergencies and divorces are all traditional tipping points for a bankruptcy. The important thing to remember is “beyond your control” – losing a big chunk of money to an investment or an out-of-control Amazon buying habit, or some other financial choice you made that sends your finances careening, doesn’t count. You have to be able to demonstrate that you could not avoid the circumstances that led you to file for bankruptcy.

When a bankruptcy results from extenuating circumstances, it can mean a shorter waiting period on all types of mortgage loans.

The waiting periods are:

• FHA, VA, USDA – One year after discharge;
• Conventional – Two years after discharge.

Steps to Improve Your Credit Scores after Bankruptcy

There’s one thing that’s true when applying for a mortgage, whether it comes after a bankruptcy or not – credit score is king. The better the score, the quicker you will be approved and the lower the interest rate will be. The interest rate makes a huge difference in your monthly bill, as well as how much you pay over that 30 years.

The fastest way to repair your credit for a mortgage after bankruptcy is to make on-time payments on all debt, (especially credit cards) and to keep the amount you use to less than 30% of the credit limit, which is the credit utilization rate.

Payment history and credit utilization rate account for 65% of your credit score. Missed payments and overspending with credit cards are credit-score killers.

Other factors are length of credit history, credit mix and new credit. It helps your score if you have a variety of credit (mortgage, car loans, student loans) and can balance using credit cards you’ve had for years with using new ones.

The whole thing may seem a little abstract, but if you do the math on a 30-year mortgage the difference between a low and high score brings it into focus. On a $250,000 mortgage, a 3.5% interest rate means a $1,122.61 monthly payment. A 4.5% interest rate would mean a $1,266.71 monthly payment.

That’s a difference of almost $52,000 by the time the mortgage is paid off.

Credit score requirements for conventional mortgages differ among lenders, but generally the score has to be at least 620. VA loans also require a 620 minimum. USDA mortgages require a 640 minimum.

Applicants for FHA loans can have a credit score as low as 500 to 579, but those loans require a 10% down payment; a credit score of 580 to 620 requires a down payment of 3.5%. The lower credit scores also mean higher interest rates.

A bankruptcy will cause a credit score to plunge, but there are things consumers can do to lessen the impact.

The first thing is to get a solid understanding of your finances. Make a budget that lists expenses and income. Figure out ways to lower expenses and increase income.

The best way to raise your credit score is to pay your bills on time, since FICO and other credit scores base a large part on credit history and the amount owed versus credit limits. The best way to attack that is to stop using credit cards, or at least keep the amount you owe below 30% of available balance.

Keep in mind that interest rates on credit cards are also determined by credit scores and can range from 16% up to the high-20s, so using them less and paying them down is a win-win.

Debt management programs, offered by nonprofit credit counseling agencies, can provide advice on your budget, how to get credit card payments down and how to improve your credit.

A credit counseling agency may also recommend a debt management program as a way to reach those goals. The agency acts as the intermediary between you and the credit card companies. They work with card companies to reduce your interest rates. You decide if the lower rate works for you. If so, you make one monthly payment to the credit counseling agency, and the agency disburses the money to each credit card company in agreed upon amounts.

This comes with a monthly fee, but the reduced interest rate more than makes up the difference.

Taking advantage of a plan to help repair your credit after a bankruptcy could be a major step toward achieving the dream of owning a home.