The two biggest mistakes of consumers that challenge the probability of the mortgage system to forgive are bankruptcy and foreclosure. Both are recorded in the borrower’s credit file and will usually stay there for an extended period of time: Foreclosure and Chapter 13 bankruptcy remain for seven years, and Chapter 7 bankruptcy for 10 years.
Both cause an instantaneous and harsh reduction in the borrower’s credit score. However, because the scoring system weights new information more heavily than old information, it is kindly forgiving of past misdeeds, provided that the new information generated by the borrower is favorable.
It seems that lenders may have a longer memory than credit scorers. They set minimum time periods for “forgiveness,” independently of and without regard for credit scores.
About 95 percent of all mortgages being written today are sold to Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration (FHA). These agencies set the rules that lenders implement. However, lenders can be much tougher than the agencies and many are because they don’t want high default rates.
Fannie Mae requires the following waiting periods before a borrower becomes eligible for a mortgage the agency will purchase: two years after a Chapter 13 bankruptcy; four years after a Chapter 7 bankruptcy; and five years after a foreclosure.
Borrowers who have been foreclosed on, furthermore, must put 10 percent down, have a credit score of 680, and must wait an additional two years before they become eligible to purchase a second home or an investment property. Freddie Mac’s rules are the same.
But the agencies include provisions for “extenuating circumstances,” which, if met, reduce the required waiting periods — to two years on a bankruptcy and three years on a foreclosure.
Extenuating circumstances are credible excuses for the bankruptcy or foreclosure that can be interpreted to mean that the likelihood of a recurrence is extremely low. The case is made in what lenders call a “cry letter”. It can be very effective if done correctly.
The burden of proof is on the borrower. The agencies will be looking for a multiple-cause explanation for the bankruptcy or foreclosure. People lose their jobs; they get sick; they have accidents; they suffer deaths in the family; they are victimized by fraud; etc. Not one of these in itself is likely to be viewed as an extenuating circumstance, but a combination of them might.
The agencies will also look for evidence that, whatever the causes of the past problem, the current situation of the borrower is one that is reasonably secure against a recurrence. In addition, they want the borrower to document that since the occurrence of the bankruptcy or foreclosure, the borrower’s capacity to handle financial affairs has improved.
A rising credit score and an ability to make a significant down payment on a forthcoming loan are good evidence of this.
Every aspect of loan underwriting has gotten tougher, and the ability to plead extenuating circumstances is no exception.
FHA’s rules on bankruptcy, foreclosure and extenuating circumstances are more liberal than those of Fannie and Freddie. For example, under FHA rules a borrower must wait only two years following discharge from a Chapter 7 bankruptcy, and they can qualify while they are still in a Chapter 13 bankruptcy. They need only to document that all payments within the bankruptcy plan have been made on time for a year, and that they have permission from the court to take a mortgage.
Be diligent and hire a qualified mortgage professional who can help steer you through this complex transaction.