Improving or fixing your credit scores to purchase a home is usually the first step future homeowners make when preparing for a home loan. There are some mistakes, however, I see all that time that costs them thousands of dollars that could be better utilized for their down payment, closing costs, or pre/post-closing expenses. Let me elaborate).
Most people who are looking to fix their credit to purchase a home will do one of two things:
1. Locate all of the negative items on their credit reports and send a dispute letter for each one.
2. Locate all of the negative items on their credit reports, pick up the phone and start paying all of them off.
Both actions are wrong, wrong, wrong!
To start, not all of your negative accounts are worth disputing. Also, paying off a few of the items on your report will do more harm than good. Can you imagine shelling out thousands of dollars on old debts only to see your credit scores drop? Well, that’s many of the people I consult with each month’s reality.
Let’s take a look at some of the items you may want to ignore:
1. Charged off accounts
Not all charged off accounts are negatively impacting your scores. For example, if my client has an account that was opened in 2010, and went negative and charged off in 2015, and subsequently paid it off (settled or paid in full), I typically leave it alone. It has a $0 balance, it has 4-5yrs of positive payment history, and removing it will more than likely drop your scores. So in this case, ignore it.
What if it’s unpaid? Then the type of loan you plan on obtaining comes into play. If you are obtaining conventional financing, the chances of your having to pay it are pretty high. Interestingly enough, per their approval guidelines, as long as you are purchasing a single-family home you are not required to pay it, no matter what the amount. Seeing that put in action, however, is an entirely different story.
In most cases, you’ll need to pay it off, settle it or find an error and dispute for deletion (and hope that it comes off) if you want to get approved. How old the charge off has to be but before it’s considered varies, I’ve seen some conventional lenders go back as long as 5 years.
If you are going FHA, it can be ignored unless the lender requires it to be paid off. FHA guidelines don't require charge-offs to be paid IF you can get approved through their automated underwriting system. So, if you don’t want to pay it, that should be your goal. If you don’t get an automated approval, or your file gets sent to manual underwriting, then 5% of balance due on your charge off will be factored into your debt-to-income utilization.
A workaround that I recommend with my clients is to get pre-approved with a lender that has no overlays. Lender overlays are the approval guidelines that they put in place on top of what FHA, Conventional, etc has already mandated. So, if you have no plans on paying off a charge-off; get approved with a lender that does not have overlays and you won’t have to pay it off.
Now, let’s get into FICO Scoring. If that charged off account is new; you’re going to want to get it to $0 to score better. An unpaid charge-off will always be scored more harshly than a paid one. Do this a minimum of 3mths before you sit down with a loan officer so that your scores have an opportunity to adjust. Further, you want a bank to lend you 6-figures and you haven’t been paying your debts on time recently? Be realistic, prepare and get your finances in order first, then sit down with a loan officer.
Collections are not created equal when it comes to mortgages, and again, the type of loan you are getting matters. FHA is more lenient. Medical collections are completely ignored and are not factored in your debt-to-income ratios, nor do they have to be paid off, no matter what the balance is. Regular non-medical collections are always negative, but even still, FHA does not require them to be paid. Their rule is if the collection has a balance over $2000, they will take 5% of the balance and factor it into your debt-to-income ratio. You’ll find, however, that most lenders will require you to pay off any collections over $2000; this is another example of a lender overlay.
Conventional financing, however, works a bit differently; a collection is a collection. If you are purchasing a single-family home, and the other areas of your financing (stability of employment, debt ratios, savings, etc.) are on point, then they may not require you to pay it off. If that’s not the case, be prepared to dispute it or settle it. I prefer the former first, latter only when fully validated.
Before disputing or paying, please check your statute of limitation first. The statute of limitations is a law that varies per state, that mandates how long a creditor has to sue you for a debt. Debts that are past your state’s statute of limitations are usually pretty old, and a lender (FHA in particular) may ignore them. Conventional usually doesn’t. I had a client that had a collection from 2012 and they still wanted her to pay it off; it was over $7600. She came to me, we got it off, and she was able to get approved for her home loan.
FICO Scoring: New collections are the ones you want to focus on, 24mths and younger specifically.
3. Public Records
Judgments & Tax Liens –
Many credit repair professionals, without knowledge of underwriting guidelines, will tell you that as long as they remove it from your credit reports, you’re all good. LIES.
As a part of the underwriting process, lenders will run a public record search using LexisNexis, DataVerify, or another public record database firm. If a lender cannot access your public record information, you will not be able to proceed with the loan approval process. (FYI: Underwriting is when your loan application and supporting documentation is analyzed and verified prior to fully approving and releasing the funds for your loan).
Judgments and Tax Liens will either need to be paid/settled in full, or be on a written payment plan for a minimum of 3 months or more. The older the judgment is, the more likely a creditor (and even your state and the IRS) will be willing to settle. Some lenders will require you to pay it off before closing; while other lenders will require you to pay it at the closing table, where the title agent will take payment and record it as satisfied.
FICO Scoring: You want that bad boy GONE. Public Records tank credit scores, especially if it’s newer. If it’s older, it’s not affecting your scores as much, but it’s still affecting it; whether it’s paid or unpaid!
When you complete your loan application, it will ask you if you’ve filed bankruptcy. If you lie, you’ve just committed mortgage fraud. If you are applying for an FHA loan and you lie (most people who have filed for bankruptcy in the past couple years do) they may ban you in their Limited Denial of Participation system; where you won’t be able to use an FHA loan for a nice little period of time. It’s just not worth it. Tell the truth. Yes, a lender will see the bankruptcy on their public record search report, but they pull that to compare to your completed loan application. Imagine how it will look, if you said ‘No, I’ve never filed bankruptcy’, they pulled your report and found it wasn’t there, then did a public record search and it says you filed 3 years ago? You are not a trustworthy borrower, and an untrustworthy borrower is risky. No loan for you.
Yes, I would attempt to remove a bankruptcy, because your scores will more than likely increase. Keep in mind that removing a bankruptcy is pretty difficult for most, so don’t beat yourself up if it doesn’t come off when you dispute it one or three or more times. It is what it is. Focus on rebuilding and saving up, paying on time, and ensuring your debts are super low so that when a lender runs your debt ratios and requests your bank statements to see how much income you make and money you have saved; you’ll wow them ?.
Hopefully, this helps as you prepare your credit for home ownership. If I can offer any further advice, it would be to get those scores up as much as possible, bring down your debts as much as possible, save and search for free money as much as possible.
Yes, some lenders will approve you with a 580 credit score and a 56% debt-to-income ratio; but please believe it comes with a higher interest rate, manual underwriting where you’ll experience more scrutiny, have to submit more paperwork and a lot of frustration than if you are getting an automated underwriting approval.
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