A Look at the Impact of “Derogatory Issues” on Credit
A financial crisis can strike anyone. It seems we have all had clients who were once thriving but now are facing difficult decisions regarding their finances. The reasons vary, but the outcomes are similar. The people come from all walks of life—lawyers, dentists, truck drivers, teachers, the list is endless. Here is some good news: Nothing will keep us down forever. Everything has a limitation on how long it can affect our credit. Most derogatory issues have a seven-year limit, Chapter 7 bankruptcy stays on credit reports for ten years, but nothing is forever. The Fair Credit Reporting Act provides the details of how long derogatory items can remain on the credit report.
The reality is that for most consumers facing turmoil today, they will be eligible to purchase a home again in three years. Federal Housing Administration (FHA) guidelines allow for someone to purchase a home three years after a foreclosure, as long as there has been nothing delinquent after the original event. For example, let’s say that two years after a foreclosure, I have a dispute with a satellite television company, and they report a collection on my credit report. Anything negative (such as this dispute) after the original event (the foreclosure) could potentially derail my chances for being approved at the three-year mark.
Someone who had an FHA, Veterans Affairs (VA) or United States Department of Agriculture (USDA) Rural Housing loan previously may have a federal claim against them in the Credit Alert Verification Reporting System (CAIVRS). They would have to wait three years from the date the federal claim was paid, which generally adds six to nine months to the timeline. Any mortgage lender can check the Housing & Urban Development (HUD) system to see if there is a claim against the borrower.
Keep in mind that the three C’s to an approval apply: credit, capacity and collateral. The borrower still has to have two years of continued verifiable employment, they must make enough money to qualify for the purchase, and they must have the minimum required down payment (3.5% for FHA). There will be a lot of scrutiny for someone who has had a past foreclosure (or short sale, bankruptcy, deed-in-lieu of foreclosure, etc.). The back end debt-to-income ratio for an average consumer is generally 41% or more; for someone coming out of a financial crisis, the debt-to-income ratio may be a maximum of 36%.
Impact of Adverse Credit Events on the Ability of Consumers to Purchase Another Home
NAR has posted a chart showing FHA, Fannie Mae and Freddie Mac credit policies for short sales, deeds-in-lieu, foreclosures and bankruptcies.The Facts about Your Credit Score
This article from the June 2010 issue of Arizona REALTOR® Magazine explores what you should know about that pesky three-digit number known as your FICO score.
As far as credit goes, many lenders require a minimum credit score of 620; some require 640, so this can be a hurdle. It is critical that borrowers have “enough” credit, which is generally three accounts open for the past 12 months plus a rental history. Traditional credit, the type included on a credit report (credit cards, auto, student loan, etc.), is preferable, but that’s not always the case. Alternative credit is non-traditional credit, such as utilities, cable, cell phone and other accounts that generally do not appear on the credit report. Paying the electric bill on time every month takes on greater importance simply because the borrower may have to go to the utility company for a letter of credit. The alternative credit must be paid on time. I have had clients compile the alternative credit documents, but if the payments were not made on time, it is unusable.
Rent payments should be made by personal check when possible. Copies of the cancelled rent check should be obtained and saved to prove the rent payments were made on time. Paying cash can come back to bite consumers if the landlord cannot or will not verify rent or if the landlord is at arms length. If the landlord is at arms length, or disappears, it will be imperative to prove the rent was paid on time for the past 12 months.
Consumers should save all documentation they receive. This goes without saying, but I have had clients who have shredded their entire bankruptcy package. Fortunately bankruptcy paperwork can be obtained at the federal courthouse if it has been misplaced. The reason saving all documents is so important is because the bad debt market buys and sells old debt, which could result in issues needing to be resolved. It is difficult to resolve these issues without documentation; the old adage of “he who holds the sword rules the land” certainly applies to the world of debt. The most common issue is a credit card that reaches charge-off status (180 days delinquent). It is placed into collection, which likely means it will be sold in a portfolio on the bad debt market. The debt is purchased for 5% – 20% of the original amount; it then shows up as a collection on the credit report. This can be problematic if the date of delinquency is changed, which is not uncommon, so saving all documentation for future reference is a smart move.
How long should this documentation be saved? Most people answer seven years. Although that may be generally true for tax audit purposes, it is not the case for bad debt since it carries a declining value, yet always has a value to third parties. For example, a collection stemming from a vehicle repossession ten years ago may still be worth 1% – 5% of the original collection amount. If someone can purchase an old debt of $10,000 for $100, there is motive to abuse the debt collection system and potentially break the law in pursuit of the old debt. Consumers should be aware of the importance of holding onto documentation since they very well may find themselves in a position of needing to prove something, especially dates. The cleanest method of documentation is the credit report itself; saving copies annually of a credit report is an excellent practice to keep a record of all important account dates. It is one of the best protections against abuse and can be handy when requalifying for a mortgage. The only government-mandated source for a free credit report is www.annualcreditreport.com.
The borrower will have to explain in a letter three important points to the underwriter:
- Why did the foreclosure, short sale or bankruptcy occur?
- Why was the event out of their control?
- Why is it unlikely the circumstances will repeat?
Approval is at the discretion of the underwriter based on perceived risk, so this explanation is important. The bottom line is that when consumers who have a past financial issue are ready to consider buying a home again, they should consult a lender to see how their specific situation applies. The lender should give them an assessment of where they are now and what needs to happen in order to qualify for a mortgage.