Mortgage Options for Former Debtors

Mortgage Options for Former Debtors

Journal Issue: 
Column Name: 
Journal Article: 
In the past, traditional mortgage lenders automatically rejected people who had declared personal bankruptcy. Many potential homebuyers felt they must wait at least seven to 10 years after a bankruptcy to be eligible to become homeowners. Most financial and legal professionals (including many loan officers) will state emphatically that there is a two-year waiting period from the discharge date of a chapter 7 bankruptcy and at least a one-year wait after the discharge of a chapter 13. This is a common misconception.

Though bankruptcy is certainly a major blemish on a credit report, it does
not necessarily disqualify a borrower. Recognizing that sometimes bad things happen to good people, some mortgage companies are becoming more willing to take a calculated risk. Some of the newest, most aggressive loan programs can even offer up to 100 percent financing just one day after the discharge of a chapter 7 bankruptcy.

Hand Underwriting

Most lenders currently use Fair Isaac's FICO scoring system to determine whether potential buyers are a worthwhile risk. Unfortunately, bankruptcy automatically gives a low score, regardless of the events leading up to it. A few select loan programs look beyond the scores and look at the individual's overall credit record. Hand underwriting, as it's called, allows a lender the chance to underwrite a loan on it's overall merit rather than just blindly accepting a flawed credit score. "Extenuating circumstances" can be taken into account, and loans can be made.

The documentation of extenuating circumstances gives an underwriter greater freedom in his or her decision-making process. In most loan programs, there are differences between the guidelines and the rules. Generally, the rule allows for shorter waiting periods after a bankruptcy than the guideline. For example, FHA guidelines stipulate that in general, a borrower must wait two years after a chapter 7 bankruptcy before they qualify for FHA financing (HUD 4155.1 Ch. 1 Sec.1 2-3 E). The rule is that an underwriter may approve a borrower for a loan at not less than one year as long as the bankruptcy was due to extenuating circumstances out of the borrower's control and there are sufficient compensating factors such as cash reserves or time on the job or at their current residence (to name a few) documented in the file to warrant the exception. It is the loan officer's job to make sure that the loan is packaged in such a way as to keep the waiting period to the shortest time period as possible as long as it is in the interest of the client to do so.

If a buyer cannot get approved, there are customized plans that can re-establish credit to help the buyer become "mortgage ready," ensuring home ownership in the future.

Extenuating circumstances that a loan underwriter may consider are events such as prolonged, catastrophic illness, an accident that either permanently or even temporarily disabled the family breadwinner, prolonged job loss out of the borrower's control and business failure not resulting from the owner's financial mismanagement.

It is interesting to note that divorce is not considered a reason in and of itself worthy of an underwriting exception. However, events that are caused by the divorce may indeed warrant exception to the rules. A common example is when at the time of divorce all debts are split between the spouses, each taking responsibility for their share. At some point, one spouse stops making payments to creditors and either defaults or declares bankruptcy, leaving the responsible spouse to pay all of the bills. Often, this is accompanied by a default in child support at the same time, leaving the ex-spouse with more debt and less income, forcing no choice but bankruptcy.


A common misconception is that a previous bankruptcy on your credit report will require you to have a large down payment and pay extremely high interest rates and points. Actually, there are programs that allow as little as 3 percent down and even some that require no down payment at all, with very attractive rates and fees. FHA, Federal VA and the newer Emerging Markets program are examples of loan programs that have very attractive rates, low or no down payments and are very favorable to borrowers that have had a personal bankruptcy. In each of these programs, underwriting exceptions can be made to allow persons a new home loan in as little as one year out of a chapter 7, and in the case of FHA, you can actually still be in a chapter 13 and get a home loan with your trustee's permission (HUD 4155.1 Ch. 1 Sec.1 2-3 E).

Aggressive Options

The sub-prime lending market has become increasingly competitive in rates and fees and responsive to the needs of the consumer. Even if a person doesn't qualify for one of the above programs, he or she may still qualify for a great home loan with little or no down payment. The downsides to these programs are typically a two- to three-year prepayment penalty and higher rates and fees. Many companies now have no waiting period after a bankruptcy and are willing to offer 100 percent financing immediately after the discharge of a personal bankruptcy.

A few of the most aggressive lenders will even lend up to 100 percent of the value of a home only one day out of foreclosure. These loans are very credit score-driven, and due to the high rates of errors on a credit report after a personal bankruptcy (approximately 98.2 percent), they can be difficult to qualify borrowers for at times. The middle score of all three bureaus is used and typically will need to be over 600 for a borrower to qualify. This condition may slow the home-buying process down for post-bankruptcy borrowers, but can usually be solved with a good letter-writing campaign and personal follow-up from the borrower to update all of the accounts on the credit report reporting in error.

It should be noted that a borrower with less than a 600 credit score is not disqualified, but would not typically qualify for 100 percent financing. Middle credit scores as low as 500 are acceptable to most sub-prime lenders and would simply be approved at a lower loan to value. These lenders also tend to be more lenient on the source and seasoning of funds to close than a traditional conforming or government loan would be, making it easier to come up with a down payment. Often, a down payment can come from virtually any source as long as the money itself is drawn from the borrower's bank account for closing.

Becoming "Mortgage-ready"

No matter what the situation, select mortgage professionals who have a program that will work for the buyer with a bankruptcy history. If a buyer cannot get approved, there are customized plans that can re-establish credit to help the buyer become "mortgage-ready" in the future. It is important for a borrower to work with a knowledgable professional who has experience in working with those who have been through a bankruptcy.

Bankruptcy no longer needs to stand in the way of home ownership. With the help of more creative lenders, those who have experienced difficulty will have an easier time getting a mortgage. Clients should be made aware of these programs as early in the rebuilding process as possible. "Mortgage-ready" programs can serve as a valuable tool to help borrowers get back on their financial feet and start becoming productive members of society as quickly as possible.

Journal Date: 
Tuesday, March 1, 2005