If you’re planning to take out a loan in order to finance a home purchase, proof of economic stability is critical. Lenders want to know you won’t default on your loan. What happens if your financial position has been… less than stable at times?
Perhaps you’ve filed for bankruptcy in the past. Are you out of the real estate market permanently? Then, there’s your mediocre credit score. Finally, what’s all this about a waiting period? You don’t want your first home to be a retirement home!
Never fear. We’ll examine challenging financial situations with straightforward explanations and suggest some sound strategies. We’ll walk through waiting period worries and expound on the meaning of extenuating circumstances.
Buying Real Estate After Bankruptcy
The short answer is “yes.” You can own real estate if you have filed for bankruptcy. Let’s clarify what bankruptcy is and the forms it can take.
Bankruptcy is a filing done with a U.S. bankruptcy court by an individual when they cannot pay their debts. Declaring bankruptcy is a legal process in which an individual minimizes or eliminates their debts through methods that a court has approved. Often, individuals seek legal or financial counsel, as navigating bankruptcy is highly complex.
Please note, before pursuing any legal action (including bankruptcy), you will want to speak with a qualified legal professional. For the purpose of this post, we are going to keep it streamlined. We will focus only on bankruptcy basics as they affect purchasing real estate.
Types of Bankruptcy
For individuals, there are two types of bankruptcy, Chapter 7 and Chapter 13. In either case, there are two outcomes. The court can dismiss or discharge the bankruptcy. If the court thinks the individual did not meet the qualifications for entering into bankruptcy, the court issues a dismissal.
Let’s examine what a discharge looks like for each Chapter 7 and Chapter 13.
Chapter 7
If a Chapter 7 bankruptcy is discharged, the individual will agree to certain conditions (e.g., selling assets to help to offset a portion of the debt), but they will not have to repay the remaining debt amount. Entering into Chapter 7 bankruptcy is often the choice for individuals without a steady income or an income that is below a state-recognized minimum.
In most situations, the bankruptcy will remain on the individual’s credit report for ten years. The positive takeaway (yes, there is one) is that one can apply for a mortgage before the ten-year period ends.
Chapter 13
If a Chapter 13 bankruptcy is discharged, the individual is able to pay back a portion of their debts over a span of years. Individuals with a steady income often pursue a Chapter 13 bankruptcy since they have the resources to make payments. A court-appointed trustee works with the individual on the specifics of the repayment plan.
A Chapter 13 bankruptcy will appear on one’s credit report for seven years. As with Chapter 7, one can apply for a mortgage while the bankruptcy record exists.
More Than One Bankruptcy
What if an individual has had multiple bankruptcies? The good news is that purchasing real estate remains an option for them.
Beyond Bankruptcy
Okay, bankruptcy won’t slam the door on potential home ownership. That’s great, but what is the first step we have to take? We need to understand the prerequisite to obtain a mortgage: the waiting period.
Each type of mortgage has its own requirements based on the type of bankruptcy filed by the applicant. (Helpful hint: check out my blog post dedicated to explaining mortgage types) Perhaps, the most relevant requirement to a potential homeowner is the period of time an individual is required to wait before applying for a mortgage.
We’ll break down mortgage waiting periods associated with mortgage type and bankruptcy type. Keep going!
Understanding Mortgage Waiting Periods for Chapter 7
Sometimes it’s easier to understand a concept and the iterations of that concept if there’s a story tied to it. To that end, let’s meet a cast of characters.
We’ll study their stories to understand the steps involved with seeking a mortgage after two events have occurred.
- A Chapter 7 bankruptcy has been filed.
- A U.S. bankruptcy court has dismissed or discharged the Chapter 7 filing.
Conventional Mortgage Waiting Period
Lewis and Lily can’t wait to move past the financial missteps of their past. They are in stable jobs and have managed to save some money for a downpayment. A conventional mortgage makes the most sense for them.
Lenders often follow the guidelines of Fannie Mae and Freddie Mac, the two federally backed mortgage companies. Both institutions require a four-year waiting period for loan applicants.
While Lewis and Lilly’s Chapter 7 bankruptcy remains on their credit report for ten years, they start approaching mortgage lending firms after four of the ten years have passed.
Federal Housing Authority (FHA) Mortgage Waiting Period
Alastair and Eloise are recovering from the financial losses they sustained during the COVID-19 pandemic. They are seeking a mortgage that is flexible in terms of a lower down payment and less-stringent credit score requirements. A government-insured mortgage issued by an FHA-approved lender provides this type of flexibility.
FHA mortgage lenders offer a two-year waiting period. If Alastair and Eloise are able to show they are facing extenuating circumstances, they may be able to get an FHA mortgage after only one year (We’ll cover extenuating circumstances in more detail in an upcoming segment of the post).
United States Department of Agriculture (USDA) Mortgage Waiting Period
Jessy is recently divorced and wants a fresh start among the wide open spaces of the U.S. Midwest. As she rebuilds her income, she needs a mortgage that doesn’t require a large down payment and has a low-interest rate. A USDA mortgage (one that is issued or backed by the U.S. Department of Agriculture) is set up for those who want to buy a home in a rural area and may have a moderate or low income.
USDA mortgage lenders offer a three-year waiting period. Certain aspects of Jessy’s divorce may be viewed as extenuating circumstances, and she has improved her credit score. For those reasons, she may not have to wait three years.
Department of Veterans Affairs (VA) Mortgage Waiting Period
Casey served two military tours in Iraq. Returning to the United States, he launched his own business, which floundered during COVID-19. Casey is rebuilding his finances and wants to own a home.
The VA works with mortgage lenders nationwide, guaranteeing a portion of each VA loan. With this assistance, lenders offer VA loans with favorable terms (e.g., lenience with credit scores), and the waiting period is only two years. If the circumstances that led to the bankruptcy are viewed as no fault of the individual, the waiting period is a year.
Understanding Mortgage Waiting Periods for Chapter 13
To illustrate the waiting periods for Chapter 13 bankruptcy, we will stick with the same approach we used for Chapter 7 bankruptcy. There is a key difference with Chapter 13 bankruptcy, of which you should be aware. The court will need to approve any loan the individual wants to take during the years granted to the individual to repay their debts.
The upcoming scenarios involve people seeking a mortgage after two events have occurred.
- A Chapter 13 bankruptcy has been filed.
- A U.S. bankruptcy court has dismissed or discharged the Chapter 13 filing.
Conventional Mortgage Waiting Period
Dominic worked through his five-year payment plan established by the court. By juggling a few different jobs, he has saved some money. Two years after his Chapter 13 bankruptcy was discharged, he was able to apply for a conventional mortgage.
Karen filed for Chapter 13 bankruptcy as a result of mismanaging her finances. The court determined her case did not meet the criteria and dismissed it. Karen had to wait for four years to apply for a conventional mortgage.
Everett filed for Chapter 13 bankruptcy after his home was devastated by a hurricane, an extenuating circumstance. The court discharged and allowed him to enter into Chapter 13 bankruptcy. Everett needed to wait only two years to be considered for a conventional mortgage.
Pablo’s home and business were wiped out by a tornado. Though Pablo’s filing was dismissed by the court, Pablo was able to pursue a conventional mortgage after two years.
Federal Housing Authority (FHA) Mortgage Waiting Period
The United States Department of Housing and Urban Development (HUD) set the rules for FHA loans. Recall these loans have more flexible terms and benefit those with mid-to-lower incomes.
Kim was seeking an FHA mortgage. There are two prerequisites for this type of mortgage. The first is proof that she has adhered to her repayment plan for 12 months, and the second required Kim to obtain permission from the bankruptcy court.
United States Department of Agriculture (USDA) Mortgage Waiting Period
Erin looked forward to starting over in the country, where she planned to eat a lot of peaches. She decided to pursue a USDA mortgage, available three years after her Chapter 13 bankruptcy, provided she completed her repayment plan. If Erin wanted to apply sooner, she had to show one year of meeting the obligations of her repayment plan.
Department of Veterans Affairs (VA) Mortgage Waiting Period
After retiring from the U.S. Air Force, Tom invested his life savings in cryptocurrency. Hackers wiped out thousands of digital wallets, including his. Also, Tom learned he should limit his interaction with penguins to visiting the ones at the zoo, as opposed to collecting the digital penguins waddling around cyberspace.
Determined to start again, Tom worked his way through his five-year payment plan allocated to him as part of his Chapter 13 bankruptcy. After one year of making payments in accordance with the schedule, Tom was able to get a VA loan.
We’ve covered the basics of how bankruptcy affects one’s ability to get a mortgage. From there, we examined the waiting periods associated with the different types of mortgages. Next up, we look into how to obtain a mortgage.
Obtaining a Mortgage
It may come as a relief to know that tasks associated with obtaining a mortgage after bankruptcy does not differ significantly from obtaining a mortgage without bankruptcy.
A Lender’s Perspective
Let’s step away from our role as the borrower (a.k.a., mortgage applicant) for a moment. Let’s look at this concept from the perspective of a lender. It helps to have the other party’s view sometimes.
As a lender, you want to know that your loan will be repaid. If the applicant has a bankruptcy that is part of their financial history, how do you know they are going to be able to repay their loan?
You’ll want some proof. You will look at the applicant’s credit history after the bankruptcy, which shows what kind of financial decisions they’re making.
Let’s go back to our role as the borrower with the lender’s perspective in mind.
Knowing that the lender who is in charge of issuing your mortgage is seeking proof of sound economic decisions, you want to improve your credit report. It will serve as proof that you are on the right financial track and that you are capable of repaying the loan.
Rebuilding the Credit History
What can you do to show that you’re on the right financial track?
Recall the debts that led to bankruptcy. Consider making different choices (and remember that most of us have to reevaluate our choices throughout our lives, so don’t beat yourself up).
Below are a few ideas that may lead you to make different choices.
- Create a budget, even though it won’t show up on your credit history. It can be as simple as listing your monthly income and your monthly expenses. This gives you a complete view of what you have and what you owe.
- Minimize credit card use for discretionary purchases (impulse Target run! I’m looking at you). If you have to put the credit cards out of sight, do it.
- If you do continue to use a credit card, make every effort to pay the balance each month.
Building up a good credit history will take time—Yes, that can be frustrating. However, like training for a marathon or helping your child with homework, the preparation will reap the rewards.
Be aware that for a conventional mortgage, most lenders require a credit score greater than 600. Others, like USDA or VA loans, may consider a score between 500–600. While the aforementioned are helpful starting points, a conscientious review of preapproval requirements is a must-do.
Comprehending Extenuating Circumstances
In addition to the individual’s credit history, a lender may consider whether the borrower had a situation of extenuating circumstances that led to their bankruptcy. In such cases, a lender may be more lenient in evaluating the applicant.
What is meant by “extenuating circumstances?” Extenuating circumstances are adverse situations over which the individual had no control or influence that caused major unplanned financial hardship.
Qualifying Situations
Adverse situations that may qualify as an “extenuating circumstance’ are:
- medical bills resulting from an accident or illness
- layoff or job loss not due to performance
- divorce and other non-recurring personal situations
- disability
- caregiving for a dependent family member
- natural disaster/property accidents
Evaluation of the Qualifying Situation
Each mortgage lender will have their methods of evaluation. Generally, they are looking for third-party validation to support the situation that occurred.
Documentation that provides evidence may include
- Hospital bills.
- Doctor’s office invoices.
- Notice of the termination of employment.
- Letters from the health insurer agreeing to pay for medical services.
- Divorce decree.
- Evaluations or assessments from third parties attest to the damage (e.g., arson or police reports).
- Claim settlements.
Conclusion
Take a moment to congratulate yourself as you’ve completed a thorough study of an uncomfortable topic. No one wants to dwell on the idea of bankruptcy, just as no one wants to think about dying. That said, we need to know the legal processes surrounding both to protect our loved ones and interests.
By reading and studying this post, you’ve chosen to be informed about the types of bankruptcy and their effects on getting a mortgage. You enhanced your knowledge of the respective waiting periods that accompany the various mortgages. Even better, you know what you can do during the waiting periods to improve your financial records!
Finally, you went a step further to understand the nature of extenuating circumstances. You can look at your individual situation and determine whether it fits the definition.
****If you are interested in keeping up with my blogs. Please join my newsletter or my Facebook group, Home Buying & Selling Resource Community. If you are on the fence about buying a house, pick up a copy of my book Essential Advice for Buying Your First Home and Navigating Through the Mortgage Loan Process. I just released a second book A Look Into the Secrets of Credit Repair: How to Fix Your Score and Erase Bad Debt. It’s available on Amazon in print, kindle, or audiobook format.
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