Making the impossible possible: How to salvage your credit after a financialcrisis
Bad things can happen to good people — unemployment, divorce, medical problems. It's life. If not tended to carefully, these bad things can result in more bills than you can pay and, in extreme situations, bankruptcy or foreclosure. While these events can devastate your credit score, it is possible to recover from a financial crisis and qualify for a mortgage.
Why so low?
First, let's review the guidelines for negative credit. Negative items placed on your credit report, like late payments and collections, stay there for seven years, ten years for a bankruptcy. A bankruptcy or foreclosure will also disqualify you for a mortgage for two to seven years. After a Chapter 7 bankruptcy, you typically are ineligible for a government loan (FHA, VA, USDA) for two years and for a conventional loan for four years.
For a Chapter 11 bankruptcy two years must elapse from the discharge or dismissal date to qualify for a conventional loan. A foreclosure, deed-in-lieu of foreclosure, or short sale will sideline you for three years for government loans and two to seven years for conventional loans.
However, don't just focus on the waiting periods. A financial crisis can easily drop your credit score by 200 to 300 points. During the waiting period, it's important to reestablish credit, and this can be difficult as few creditors may be willing to extend it.
Getting back in good credit graces
To qualify for a mortgage, you typically need two to four active credit accounts with a history of at least 12 months. But what kind of credit can you get after a financial crisis? One option is a secured credit card. For this type of account, the creditor typically requires that you deposit money that acts as security if you fail to pay. If you have a relationship with a bank or credit union, inquire about a small personal loan.
Another possibility is an auto loan. Some creditors specialize in making auto loans to folks with damaged credit. Your interest rate may be higher, but an auto loan is a great way to establish a new, positive payment history.
It's important to keep in mind the purpose of these new accounts is not for the credit itself. Creditors are likely to offer you very low credit limits. Instead, you're doing this to improve your credit profile by creating a record of paying the accounts on time.
The added benefit of getting new credit accounts is that after a period of on-time payments, your credit score will improve. In fact, I have worked with customers who have experienced a bankruptcy who have raised their credit scores above 700 (a good credit score) during the waiting period by purposefully reestablishing credit.
To counsel or not to counsel?
Some folks seek credit counseling in response to a financial crisis. While this can be a responsible approach to getting your debts under control, please understand that it can affect your ability to qualify for a mortgage.
Credit counselors typically negotiate with your creditors to lower your payments, interest rates, and fees so that you can affordably pay off your debts. If you participate in a credit counseling payment program, you can qualify for an FHA mortgage after one year in the program with on-time payments. You also must receive permission from the credit counselor.
The appearance of credit counseling on your credit report does not affect your credit score. Instead, creditors may report that you're not paying your accounts as originally agreed, and that will depress your score. It's also true that many folks don't seek credit counseling until they've already hurt their scores by getting behind on their payments.
Don't ditch credit
After a financial crisis, some folks swear off credit. While this may seem financially responsible, it may make it impossible to qualify for a mortgage. (Most of us cannot afford to pay cash for our homes.)
Negative items stay on your credit report for seven to ten years. If you never add positive accounts to your credit profile, the credit bureaus only have the negative items for scoring, and your score will never recover. While we sometimes can qualify folks who have never used credit (no credit score), we never can qualify folks with low scores who have stopped using credit.
Next time, we'll look at our second factor for qualification — employment. Can you qualify if you recently changed jobs? Can you qualify after unemployment? We'll sift through all the rules. And, as always, leave me a comment if you have a special situation you want me to address.