Getting a Mortgage After Bankruptcy
Every American wants to own their own home. It’s part of the American Dream, one that insists if you work hard enough then you can live a free, prosperous life. But if you’ve previously filed for bankruptcy your own version of the American Dream may be a little different.
If owning your own home is a long and winding round, at the end of which lies a bright, welcoming light and a big, beautiful house, then bankruptcy is the giant sinkhole in the center of that road, threatening to pull everything into a hopeless abyss.
How Bankruptcy Can Affect your Ability to Get a Mortgage
If you have a bankruptcy filing on your credit report then it serves as a warning to all future creditors, suggesting that you might not be the most responsible and reliable debtor. And if that’s what they believe, why would they commit to lending you the 6-figure sum that you need for a house?
Borrowers mistakenly believe that mortgages are easy and that all home loan providers should be willing to lend at all costs. After all, they’re not lending you 100% of the house price and if you default, they can just foreclose, get their money back, and move on.
The problem is, the foreclosure process is incredibly expensive, and a bank rarely gets its money back. They need to file paperwork, pay maintenance costs, and protect their property, and that’s before they inevitably sell the house at a significant loss.
On average, the bank loses $50,000 per foreclosure. Therefore, it’s not something they will rush into and if there is any suggestion that you won’t make payments on your mortgage loan, they won’t give you a mortgage.
What Effect Does Bankruptcy Have on Your Credit?
As detrimental as a bankruptcy filing can be for your credit, it’s the way it impacts your credit score that makes the biggest difference. If you have an “Exceptional” credit score, bankruptcy reduces your total by as much as 240. If your credit score is just “Good” or “Fair”, it can reduce it by as much as 150 points.
That may not sound like a lot, but it is when you compare it to other detrimental factors, such as a hard inquiry (up to 5 points) or a missed payment (50 to 90). And that’s just the bankruptcy—it doesn’t account for any derogatory marks that may have impacted your score in the lead-up to the filing.
A bankruptcy discharge can remain on your credit report for up to 10 years, although the impact that it has on your score will reduce over time and after a few years, it will be negligible at best.
That’s a long time and a lot can happen in 10 years. But you have to see it from the lender’s perspective. A bankruptcy discharge means that you struggled to meet your payment obligations and sought government assistance to discharge all your debts, thus pardoning yourself and giving your creditors much less money than was agreed.
Your credit report is there to warn other lenders of your history, allowing them to make an informed decision, and as a bankruptcy discharge is such a significant decision, it warrants a prolonged placement.
Think about it this way, if a friend of a friend asks to borrow $1,000 and insists he will pay it back, even though he has a terrible financial record and previously begged for forgiveness of debts worth just $5 and $10, would you trust him and lend him the money? Probably not, at least not until he’s had a stable few years to prove he’s capable.
How Soon After Bankruptcy Can You Get a Mortgage?
If you have filed for a bankruptcy discharge, which is provided under a Chapter 13 bankruptcy case, you need to wait at least 2 years before you can apply for an FHA loan. These are government-backed loans, however, and they tend to be a little more forgiving when it comes to their terms.
If you get a home loan from a bank, you may need to wait 3 or 4 years, depending on their criteria.
Simply waiting for the required length of time isn’t good enough. You also need to get your credit score above 500 before you can qualify for an FHA loan and 640 for conventional loans. The higher it is, the better. In case of an FHA loan, you’ll need a down payment of 10% if your credit score is less than 580 and 3.5% if not, so it can make a massive difference.
It’s also important to remember that lenders provide better rates to borrowers with strong credit scores. On the surface, a credit score of 640 may not seem much different to one of 840. After all, in both cases, you’ll be asked to provide the same down payment, given the same total and asked to abide by similar terms.
However, a credit score of 840 is likely to get a much better interest rate. The difference may only be 0.5% or even 1%, but where home loans are concerned that could account for thousands of dollars over the lifetime of the loan.
How Long is the Mortgage Approval Waiting Period?
The mortgage approval process can take anywhere from 1 month to several months. There are several steps to complete in this time, but mostly it’s just a case of biding your time and hoping that things go your way.
In the first instance, you need a prequalification letter, followed by preapproval, the latter of which will typically require you to submit documents such as your social security number, driver’s license, and tax returns.
The final approval process will then begin, and this typically takes just a few weeks to complete, assuming there are no extenuating circumstances.
Options for Getting a Mortgage After Bankruptcy
There are a few different types of home loan you can apply for after a bankruptcy filing. Your options will depend on your credit score, income, down payment, and the amount of time that has passed since you filed.
A conventional home loan is one that’s not insured by the government of the United States. To account for this, you will be required to pay private mortgage insurance, an obligation that stops once you reach 20% equity. These loans are offered by banks, all of which have their own criteria regarding applications that following bankruptcy filings.
Federal Housing Authority (FHA) Loan
An FHA loan is insured by the federal government and aimed at borrowers with lower credit scores and down payments. You need a 10% down payment if you have a score of 500+ and 3.5% if you have a score of 580. The interest rates also improve as your score improves.
You only need to wait two years after filing before you can apply for an FHA loan.
United States Department of Agriculture (USDA) Loan
These mortgages are aimed at low- and middle-income borrowers living in rural areas. It provides a low-interest and zero-down payment option and you need to wait just 3 years after filing for Chapter 7 or 12 months after filing for Chapter 13.
Veteran’s Affairs (VA)
If you are a United States veteran then you may qualify for a VA loan, which is offered without a down payment and doesn’t require a specific credit score. You only need to wait 2 years after filing, but these loans have a long list of criteria and you may not qualify, even if you are a US veteran.
Tips to Get Approved for a Mortgage After Bankruptcy
To increase your chances of getting a mortgage loan after bankruptcy, keep the following tips in mind:
Improve Your Credit Score
Bankruptcy doesn’t give you a clean slate as such, but it does give you a chance to rebuild your credit from a new perspective. After bankruptcy you should have a new outlook, with improved financial education and an understanding of how bad things can get and how you can avoid them.
Start slow and work on improving your credit score and keeping debt to a minimum. You will be offered high-interest rate credit cards by lenders that target bad credit debtors, but you need to ignore these and get a secured credit card instead.
A secured credit card works just like an unsecured credit card, only you don’t have an endless credit limit, and everything is secured against a cash deposit. A small credit builder loan can also help you to get back on your feet after filing.
Work on your Debt-to-Income Ratio
Your debt-to-income score is used by mortgage lenders to determine how prepared you are to make the necessary payments every month. They will calculate your total debt and then compare it to your total gross income.
If you have debt payments of $500 a month and your income is $5,000, your score is 10%, which is great. Mortgage lenders will look for scores less than 43%, with anything under 30% being preferred. It’s also worth noting that your future mortgage payment will be added on top of this rate.
Keep Your Payment History Strong
Your payment history accounts for a greater percentage of your credit score than anything else. You need to keep this strong if you’re going to get a house after bankruptcy.
Make sure you meet all your payments on time, never leave anything late, and dispute everything that was not your fault. You need a clean and stable payment history to build a strong credit score.
Keep Debt to a Minimum
Every time you apply for a new credit card or loan, your credit score takes a hit. Hard inquiries and new accounts can reduce your score significantly and it may take several months for these effects to diminish.
Keep all new accounts to an absolute minimum and open only the ones that are necessary.
Build an Emergency Fund
Start saving some money to build an emergency fund as this will help you if you ever fall behind with mortgage payments. Every cent that you don’t spend on bills, debts or other essentials should go towards your emergency fund. And if you genuinely don’t have any money left over after all those obligations have been met, you can’t afford a house.
Remember what we said about debt-to-income above. The goal is to get this to 30%. That means that if you have an income of $5,000, it needs to be $1,500 or less. Assuming it’s exactly $1,500 when the mortgage payments and other debts have been factored into the equation, and we add another $1,500 for food, bills, clothing and the occasional day out, that leaves $2,000.
Even if we put $1,500 more to one side to cover other expenses, that still leaves $500 that you can place in an emergency fund. Over the course of a year, that emergency fund will grow to $6,000. In three years, you’ll have $18,000.
If you’re ever hit with medical expenses, you lose your job, or you suffer some other extreme hardship, you can use that money to cover your mortgage payments for a number of months until you get back on your feet.
Summary: Playing the Waiting Game
When filing for bankruptcy, you rarely stop to think about the way that it could impact your chances of getting a mortgage. You can’t pay your debts, bankruptcy provides you with a solution—that’s pretty much the entire thought process. The good news is that bankruptcy may benefit you more in the long run, as now you don’t have all those debts to worry about and have sought a simpler and more manageable way of clearing them.In a few years, after you have spent some time rebuilding your credit and looking at your options, you can start looking for a house and thinking about making the commitment. Time is a great healer where bankruptcy is concerned.