If you have had credit troubles in the past, you know that these things can plague you for years, making it difficult or impossible to obtain credit. If you can get new credit, often times interest rates and payment terms are ridiculous.
Why is this?
Lenders look at each borrower in terms of risk. They look at factors such as credit history, job stability, debt-to-income ratio, percentage down payment, property type, and many other factors. If you have had recent credit troubles, you are considered a greater credit risk. A person who is a greater credit risk will have a greater likelihood of foreclosure; therefore, the lender must charge a higher interest rate to compensate for this fallout in non-performing loans.
Let's start out by talking about some common credit problems and how lenders look at them. Then, I will tell you how to build your credit profile as best you can to not only obtain a mortgage, but to get the best possible terms given your past credit problems.
Credit Problems and How Lenders View Them
One of the most common problems I see on a daily basis is collection accounts. Collections generally fall into two categories: medical and other. Medical collections are not as big of a concern to lenders as they many times are not preventable. If you have minor medical collections and no other derogatory credit, you may still qualify for a prime loan (designed for those with perfect credit). However, if you have any other collections that are not medical, you will likely have to pay them off at closing in order to qualify for a prime loan. However, there are plenty of lenders out there who will approve your loan despite thousands and even tens of thousands of dollars of collection accounts.
Another problem is lack of credit accounts. What I mean by credit accounts are open and active credit lines such as auto loans, student loans, credit cards, or mortgages. If you are looking to borrow more than 90% of the sales price of a home, or you are trying to qualify for a prime loan, most lenders will require you to have at least 3 credit lines that have been open for at least 24 months. Some lenders have looser requirements, however, and will allow closed accounts to count as credit lines, or will allow "alternative" credit lines such as documentation of cell phone bills or rental pay history.
Bankruptcy is a problem that many people have faced with the tough economy in the United States the past several years. The good news is that there are lenders out there who will give you financing, sometimes 100% financing, if you are only one day out of bankruptcy.
Foreclosure on a past home doesn't necessarily disqualify you from getting a mortgage.
Judgments and tax liens can be a problem as these creditors could seek a lien against your home, which lenders don't like. However, if you can document that they have been satisfied or that you are in a pay plan, you will usually be OK. If they are not in a pay plan or paid off, you will likely have to pay them off at closing as a condition for getting the loan.
Late payments are the most common problem with people's credit. Even people with very high credit scores may have a 30 day late or two. Mortgage lates will affect your ability to qualify and what kind of terms you can get. Consumer lates (credit cards, auto loans, etc), may not affect your chances of getting a mortgage at all, unless you are attempting to get a prime mortgage.
How to Deal With These Problems
Now that we have discussed some common credit reporting problems, let's get into how to deal with them and get the best possible mortgage approval.
First of all, it is important to understand that lenders view your history over the past 24 months with the most scrutiny. For example, a bankruptcy that is more than two years old will be easier to overcome than one that is 2 days old. Late payments and collection accounts that are at least two years old will have less weight or might be ignored all together.
Furthermore, a bankruptcy will fall off your credit report after 10 years, and collection accounts and late payments, after 7 years. For that reason, if you have an old collection account that is, for example, 6 years old, it may be in your best interest to not pay it off.
In fact, you should speak with a mortgage professional before paying off any collection accounts. Many applicants mistakenly think that if they pay off collection accounts that their credit score will go up. This is not necessarily the case. The reason is that if the collection account is paid off, it will still be on your credit report, but it will just show that it is paid. When you pay it off, your credit report will show that the credit line has been active in the past couple months. The credit scoring model places the most weight on credit lines that have been active within the past 24 months. So although the collection is paid off, it is still a negative credit line, and if it was active in the past couple months, it could temporarily bring your credit score down. For that reason, on collection accounts that are more than 24 months old, I always advise my clients to wait to pay them off until after closing. If the lender requires the collection to be paid as a condition of getting the loan, the collection can usually be paid at closing.
One of the most common problems I see, especially with my clients with past bankruptcies, is reporting errors on the credit report. By this I mean that credit lines are being reported wrong. Many times, if you had a bankruptcy, the credit bureaus will still show some of the accounts open and delinquent. You can do wonders for your credit just by challenging these items and getting your credit report updated. There is more on this topic, with sample cover letters, in the credit repair section of my website.
If you have suffered a bankruptcy, one of the best things you can do to start building your credit score is to re-establish credit. By this I mean that it is essential to get some new, clean credit going as soon as possible. One way you can get the ball rolling is by obtaining a secured credit card from your bank. A secured credit card is one where you put enough money in a side account to cover the max (which is usually only a couple hundred bucks). Use the credit card each month on a tank of gas or some groceries and then pay off the balance in full. In this way, you are establishing a positive pay history. Before you know it you will be able to obtain an auto loan and perhaps a "normal" credit card. As we discussed earlier, lenders usually want to see 3 open and active credit lines, so you should work toward that goal as soon after bankruptcy as possible.
A Few More Thoughts
Another key to getting a mortgage that is worth mentioning in this article is job stability. Although this is not tied directly to credit reporting problems, you should keep this in mind if you are looking to buy a house. Lenders want to see a two year history in the same line of work. If you have been with the same employer for these two years, that's even better. Stability is key.
If you are looking to start a business, wait until after you buy the house. The reason is that lenders will not allow you to use the business to verify employment history until you can document that it has been in existence for at least two years. Therefore, it will be nearly impossible to get a mortgage, especially if you have had credit problems recently.
If you are currently renting, you should also make sure you pay your rent with a check so that you can document a paper trail of paying rent on time. In the absence of open and active credit lines, the ability to document rental pay history can make or break the deal for you. I have seen it too many times where someone is otherwise a reasonably strong candidate for a mortgage, but they can't document their rental history, so the lender rejects their application.
I hope this article has helped you with some tips on preparing for your mortgage application after suffering some credit setbacks. Getting a mortgage with poor credit can be easy if you are working with a professional who can guide you down the right path.
RJ Baxter has been a mortgage consultant for over four years. RJ utilizes his teaching background by educating consumers and advocating ethical business practices in the mortgage industry. RJ has received many awards for excellence and loan volume and has consistently ranked in the top ten among over 600 loan consultants at PrimeLending. For more articles like this, or to read more about RJ or PrimeLending, please visit http://www.rjbaxter.com.
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