One of the many heartbreaking misconceptions people can have about bankruptcy is that it means you will never be able to buy the house of your dreams… or even ever buy a house at all.
This could not be further from the truth.
Just like some things you would like to do in life with a bankruptcy on your credit history, it might be difficult at first, but by no means should you tell yourself it’s impossible. And always remember your credit history improves, and things will get easier with time.
Owning a home is something many Americans dream about and it is a big measure of economic success. It is also the single largest purchase most people will make in their lives.
For these reasons and many more, buying a home – even when your credit is good – is a big decision. Throw in the fact that you’ll be applying for a home mortgage loan with a bankruptcy on your credit reports, and it is completely understandable if you’re feeling anxious.
What to Know Before Looking for Homes After Bankruptcy
Here are some quick facts if you’ve declared bankruptcy and want to buy a home:
For a conventional mortgage loan – the kind you usually would get at your bank or credit union – there is a wait time of four years from the time your bankruptcy is discharged.
There are some government-backed loans, however, which have wait times of only two years before allowing you to apply.
Both kinds of loans require mortgage insurance to cover the bank in case there’s a problem with your payments. This is especially true after a bankruptcy, and as much as it seems unfair to be penalized further, there’s little you can do but pay for this coverage.
There are many differences between loan types than wait times, though. Just like shopping around for the right home is a necessary part of the process if you want to be happy with what you get, so too is shopping around for your mortgage.
Different mortgage loan types are just like different styles of homes and what delights one prospective home-buyer will not work for another. Mortgage loans are not one-size-fits-all. And while your options may seem somewhat limited, the market, as they say, is always open.
Government-Backed Loans After Bankruptcy
There are three types of government-backed mortgage loans – FHA, USDA, and VA – and if you’re coming out of a bankruptcy with a moderate income, these will probably be the easiest ones to get approved for.
The reason is simple: if you default on the loan, the federal government pays the mortgage lender. Don’t be fooled into thinking it’s free money to play with, though; if you do default, the government will try to minimize its losses, and that includes foreclosing on your home.
One of the many great things about government-backed loans for folks with a recent bankruptcy is that the federal government guarantees the mortgage, something lenders love, and this means you’ll be able to get a low mortgage interest rates, even if you don’t have a big down payment. However, if you put very little money down, you will have to pay a mortgage insurance premium.
Be realistic about your finances and the possible threat of a second bankruptcy should that happen. Always know your credit score, your account balance, and have money saved for the future; good advice for anyone, but especially for someone rebuilding from a bankruptcy.
Let’s take a closer look at each of these three types of loans.
1. Federal Housing Authority (FHA) Loans
The Federal Housing Authority (FHA) has strict rules for firms giving FHA-backed loans. The most important rule for you is that they will not allow an FHA loan to be issued to someone with a Chapter 7 bankruptcy discharge within the past two years. Some firms even go a step further and will not issue FHA loans to anyone with a bankruptcy in the past three years.
Don’t let this discourage you, though. If an FHA loan is what you think will work best for you, there is a lender out there willing to work with you, no matter what your credit is (after the legally required waiting period, of course).
Depending on your credit score, an FHA loan requires a down payment of as little as 3.5% of the purchase price of the home. This is much lower than the standard 20% needed to qualify for a conventional loan. In some cases – such as when you have fair credit but a lower-end income – it’s even possible to get an FHA loan through the government-sponsored firms Fannie Mae and Freddie Mac for as low as 3% down.
If you do decide to put less than 20% down on an FHA loan, you will have to purchase private mortgage insurance premiums. This differs from a conventional loan in that with an FHA loan, you will pay both an upfront premium and a monthly premium. Conventional loans usually only have a monthly premium. Both of these premiums can be rolled into your mortgage, though, meaning the cost will be spread out over time.
Your down payment is determined, among other factors, largely by your FICO score; the higher your score, the less you will need for a down payment. This is another reason why it’s so important to build your credit up as soon as possible after your bankruptcy.
The actual loan limit of an FHA loan is determined by two main factors: where you plan to buy and the average home price of that area (in other words: location, location, location). You can also only use an FHA loan to purchase your primary residence, and the residence itself must meet stricter appraisal standards. Be sure to speak with the lenders in your area for home coding regulations.
2. USDA Loans
The main stipulation regarding USDA loans is that they must be used for qualifying rural properties. Conventional loans can be used nationwide, but the USDA determines where you can use their loans. But don’t let the term “rural” throw you off; the government defines “rural” quite broadly, and they include in that definition many suburban areas. If you live in a major metro area, though, there’s a slim chance you’ll qualify for a USDA loan. You can check the eligibility of an address at the USDA website.
If the home you’re interested in is eligible for a USDA loan, don’t rush to apply just yet. There are a few more qualifications you have to meet first:
- your credit score has to be at least 640
- your household income cannot exceed 115% of the median for your area (this includes everyone living in the house, not just those with their names on the loan)
- your debt-to-income ratio shouldn’t be higher than 50%
On the plus side, because the government guarantees the mortgage, a down payment is not required for a USDA loan. Needless to say, if you’re in a situation where money is tight, this is an enormous advantage (just keep in mind those closing costs).
Aside from this, the other major advantage of USDA loans are low interest rates. In many cases they are lower than any other conventional loan you might qualify for. If the appeal of the countryside is too much to resist, a USDA loan could be the perfect tool to get you into the home of your dreams.
3. VA Loans
Loans offered by the Department of Veterans Affairs are a choice available to military veterans and in some cases, the spouse and dependents of a deceased veteran. VA loans have the same wait limits as FHA loans and follow many of the same guidelines. Depending on your credit score, you can expect low-interest rates and a low down payment.
Conventional Loans After Bankruptcy
You’ve probably heard of the 20% rule when buying a home: save enough money so your down payment is 20% of the purchase price of the home. That is generally true when you’re applying for a conventional mortgage loan. Conventional loans also require a higher credit score and a fairly low debt-to-income ratio, two things that can almost seem prohibitive to someone with a bankruptcy in the past couple of years.
That is not an attempt to scare you away from applying for a conventional loan. If the idea of a government-backed loan isn’t for you, there are ways to get approved for a conventional mortgage. But first, there is the waiting period (two to four years) before any lender will approve you for a conventional mortgage.
So why go with a conventional mortgage loan? The biggest reason is they can be used nationwide. All government-backed loans come with a list of restrictions of what kind of home it can be and where it can be located. Lenders giving conventional loans don’t really care, as long as you make your monthly payments, of course.
Conventional loans make the most sense for people who, in the four years since their bankruptcy, have built their credit up and who also have a higher than average income. The more money you can save for your down payment, the happier lenders will be. Proof of a regular, sizable income are two things that will encourage lenders to qualify you.
The government-sponsored firms Fannie Mae and Freddie Mac underwrite private loans and for this reason they often require private mortgage insurance in case you default on the loan. Just like the lender is protected by the government with FHA, USDA, and VA loans, Fannie Mae and Freddie Mac protect themselves with this mortgage insurance.
In general, private lenders will have more stringent requirements when it comes to your finances, but if your credit is in fair health, it’s possible to qualify for a solid conventional loan well before your bankruptcy is completely gone from your credit history.
Applying for a Home Loan After Bankruptcy
So you’ve picked out a house, you know what kind of mortgage loan works best for you, and you’ve saved money for a down payment and/or the closing costs.
Before you approach the lender the minute you are legally allowed to apply for a mortgage loan, however, there are a few steps you can take that will make your chances of approval improve dramatically.
Repairing Your Credit
The first step you have hopefully been making since filing for bankruptcy is repairing your credit. Allowing time to pass is a legal necessity and nothing can speed that up, but you can and should be improving your credit as soon as possible. This includes getting a credit card after bankruptcy (secured and unsecured lines of credit – see our picks for the best credit cards after bankruptcy), taking out small loans, and paying other outstanding secured debt. Also, consider using a credit repair company to help speed up the process. Taking these measures will improve your credit score, which is necessary for buying a home.
The lowest score your credit can be and still qualify for an FHA loan is 500 – but again, that is the lowest possible and therefore, not guaranteed at all. A better rule of thumb you should think of is a credit score between 620 and 640. This is possible after a bankruptcy and will show lenders that you have taken the necessary steps to get back on secure financial footing, making you a safer bet when it comes time to ask for a mortgage.
Letter of Explanation
Once the appropriate amount of time has passed, your credit score is in that robust range, and you have some money saved, write a letter of explanation. This is not a list of your financial sins to the bank, or a letter asking forgiveness for past financial misspending (if any).
This letter simply explains to the lender why you have a bankruptcy on your record. Unless you wait for the court-mandated seven or 10-year period and the bankruptcy is removed from your credit history, it raises a major red flag. A short explanation of how you came to file for bankruptcy and a snapshot of your current financial situation can help sway the mind of whoever is reviewing your mortgage application in your favor.
It is not a requirement and will probably not be asked, but it shows to a financial institution that your frame of mind is serious and focused. A home is something you clearly want and to any lender, that makes you a safer bet.
The Mortgage Pre-Approval
The next step after your credit score is in good shape and you’ve gone through the waiting period is to get a mortgage pre-approval. This letter from lenders tells you the ballpark figure of what your loan will be. Getting this letter is important because it allows you to narrow your house hunt to areas where you’ll be able to realistically afford.
In order to speed the pre-approval process along, have your past two W-2s, pay stubs, and bank statements ready. The lender will ask for them anyway, so if you have them assembled before you even apply, you can get approved quicker.
Getting the Pre-Approval Letter
Once you’ve submitted your application, the matter is largely in the hands of the lender. After reviewing your paperwork, they may have to contact you to clarify something. As someone with a bankruptcy on your credit report, this is likely to happen. Be honest and forthcoming with any questions they have, and promptness is your friend. This is where your letter of explanation can be of great use, as it shows you’ve thought ahead and have reviewed your past financial moves with an eye on the future.
Time to Buy a New Home After Bankruptcy
When you know how to recover from bankruptcy, not only is buying a house after bankruptcy possible, but it’s also possible to do while the bankruptcy still shows up on your credit report. The process may not be easy – buying something as expensive as a house seldom is – but by being proactive and showing your handle on finances is stronger than ever, there will be few obstacles you can’t overcome.
Unlike buying a car after bankruptcy, buying a house is more than an investment or a mere purchase of property; you’re buying your home, a place to build memories and a life. For your sake, it’s important to give each step of the process the attention it deserves because each step adds up to the total experience, and buying a home should be a happy one.
The process may not be easy – buying something as expensive as a house seldom is – but by being proactive, having a budget after bankruptcy, and showing your handle on finances is stronger than ever, there will be few obstacles you can’t overcome after bankruptcy.