Not so long ago, credit for mortgages was easy to obtain for almost anyone with no money down. The last couple of years have demonstrated that those policies, while helpful initially, do not sustain long term viability for the housing market.
In order to provide guidance for borrowers in this more challenging lending environment, we have put together some thoughts on how to get your clients in a position to get the best terms possible for their loan.
Pay Bills on Time
This is the most important, but often the one of the least stressed things
buyers can do to improve their credit. No bill is “too small” to pay. No bill
is unimportant (utility, medical). Lack of mindfulness on this issue is the #1problem that drives credit scores down.
Obtaining and maintaining revolving credit is very important. This type of credit should be used sparingly. The ratio of debt to available credit will affect credit. Borrowers who have a limited amount of revolving credit but high balances on that credit will see scores affected negatively.
Other non-mortgage creditors will make their decisions to approve or deny a credit application based on the current status of the other revolving accounts. Accounts shouldn’t be closed unless new accounts with similar credit limits are being opened. Even then, be careful. Closing down older accounts can erase years of credit history…especially for those with limited amounts of credit history.
Be mindful when transferring balances. While it may appeal to a borrower to transfer all debt to one card, doing so can have a negative affect on the credit score. For instance, let’s say someone has $7,000 in revolving debt spread out amongst 5 cards and wants to put that $7,000 onto one card that has a $7,000 limit. Credit is adversely affected anytime a particular revolving account is charged to its limit, regardless of what other available limits are out there.
Use it or lose it. A borrower with a very light credit profile must use revolving credit often and responsibly. If a borrower’s only positive credit is one credit card, long periods of non-use will negatively affect credit. It is best to charge groceries or a tank of gas each month to keep the account active. The balance should be paid in full each month.
Interest rate is a non-issue for someone establishing or re-establishing credit. Take the card and use it sparingly. Eventually, lower rate offers will follow. If you pay the balance monthly, the interest rate is irrelevant for now. After a period of on-time payment passes, call the credit card servicer and inquire about a rate reduction.
Most loan programs have strict credit score requirements. The presence of the minimum credit scores alone will not qualify the borrower for the mortgage. Mortgage lenders will evaluate the basis for the score. Scores may appear due to collections and negative credit driving scores down that were once high. Scores may also be based on unused or recently closed revolving/installment accounts, deferred student loans, and collections.
Generally, a score built off of a credit profile like this will not be acceptable. A credit report should consist of at least three accounts that have been paid on time for at least the most recent 12 months. These accounts can include an installment loan, a revolving account, a utility account, or any other type of account that is paid monthly.
A prior bankruptcy will not disqualify a buyer from purchasing a home, however credit history post-bankruptcy will be a big consideration. A buyer seeking conventional financing may be eligible 4 years from the filing of a Chapter 7. FHA will allow financing two years from discharge of the Chapter 7.
After a Chapter 13 or a debt consolidation program, a buyer will need to have at least one year of on-time payment history along with permission from the trustee / program to enter into a real estate transaction. The buyer needs to qualify using the monthly payment of the debt program.
The key to being able to finance a home after a bankruptcy is re-establishing credit. Avoiding credit after bankruptcy is a common and costly mistake. At a minimum, obtain a secured credit card as soon as possible and build credit from there.
Secured Credit is one of the best ways to start a new credit profile after a bankruptcy or other financial challenge. You are simply using your own money but depositing it with the bank issuing the credit card and using that money as revolving credit. Using this card and paying the balance in full each month will jump-start scarred or challenged credit.
Prior Foreclosure / Short Sale
In general, a borrower will not be able to obtain financing if they’ve had a foreclosure in the prior three years (3 years for FHA, 4 years for conventional). The lender may grant an exception to the three-year requirement if the foreclosure was the result of documented extenuating circumstances that were beyond the control of the borrower, such as a serious illness or death of a wage earner. The borrower must have re-established good credit since the foreclosure. Divorce is not considered an extenuating circumstance. However, the situation in which a borrower whose loan was current at the time of a divorce in which the ex-spouse received the property and the loan was later foreclosed qualifies as an exception.
A foreclosure generally will show on a homeowner’s credit report as a “foreclosure / repossession”, whereas a short sale or deed in lieu of foreclosure typically is reported to the credit bureaus as a”pre-foreclosure in redemption status” or “settled”. A foreclosure action does not have tox be filed in the courts to be considered a foreclosure by lenders and the credit bureaus.
Piggy-Backing Credit Accounts
Piggy-Backing is the practice of adding someone as an authorized user. Until recently, it almost always artificially gave someone a credit profile and often times would be considered as sufficient as credit that is solely obtained. This practice no longer will work. It may, however, help someone who just can’t seem to get an institution to approve them when trying to initially build credit. A credit report that consists mostly of “authorized user” accounts will not be acceptable.
Co-signers / Non-occupying co-borrowers
A Buyer needs to have sufficient credit of their own to purchase a property. A co-signer with excellent credit will not offset a borrower’s poor credit.
Collections / Charge-Off’s
A collection on a borrower’s credit report will have a definite negative impact. For a borrower who has limited credit to begin with, this type of reporting can devastate the scores. After a year, it will typically affect the credit less negatively than in the first 12 months. A borrower will want to pay off any collection as soon as possible to lessen the affect it has on their scores. A “paid” collection can remain on a credit report for between 7 and 10 years, but will affect credit far less than a collection with a balance. Occasionally, a borrower may be able to get a collection agency to remove a collection completely. Once removed, no affect will be noticed.
Charged-off accounts occur when a creditor writes the debt off as bad debt after a period of non-payment. Over time, these too will have less of an impact on credit. However, a charge-off showing on the credit report is an indication that a borrower has low regard for debt-repayment and will often times be required to be paid in full prior to be approved for a loan.
Medical collections will have less of an impact on an underwriting decision than other types of collections. Collections generally won’t be required paid prior to closing unless they affect title, but collections that remain unpaid for any length of time will have a negative impact. It will be up to an underwriter to require a collection to be paid.
Charged-off accounts occur when a creditor writes the debt off as bad debt after a period of non-payment. Over time, these too will have less of an impact on credit. However, a charge-off showing on the credit report is an indication that a borrower has low regard for debt-repayment and will often times be required to be paid in full prior to be approved for a loan. This type of adverse credit will also stay on the credit report for up to 10 years. Occasionally, charged off accounts will report on credit as having an “Amount Past Due”. These amounts will always need to be paid prior to approval for a mortgage.
If a borrower can not pay the full amount due each month, they should call the utility company and make arrangements on how to catch up without being reported to the credit bureau. It is very important to call in advance of the due date to inquire as to an extension, etc. Simply sending in less than the amount owed each month can turn into months and months of late payments, which in turn will negatively affect credit.
Multiple credit inquiries for a mortgage do not negatively affect scores when done in a relatively short period of time. What can negatively affect credit is when a borrower applies for several different types of credit in a very short period of time. A car, mortgage, a few credit cards, and store revolving charge cards applied for all at once can have an adverse affect on overall credit scores.
A borrower should not rely on an online credit score inquiry where the borrower pulls their own credit through a free or fee service. While information may be the same, the way this information is pulled into a tri-merged (three bureau) report using different scoring models is not. A mortgage company’s pull of a borrower’s credit may be 50 to 100 points different. Therefore, it is very important that a prospective homebuyer has their credit report generated by a mortgage company / lender ONLY, when considering a mortgage.
Credit Reporting Agencies