Unpaid Collections: Impact On Mortgage Approval And Your Future

When applying for a mortgage, lenders will assess your credit score and history, including any unpaid collections. While it is not always necessary to have paid collections to obtain loan approval, they are considered part of your credit history and can impact your mortgage application. Lenders will evaluate the type of debt, the amount owed, and your regular payments to determine your debt-to-income ratio (DTI). A collection account can lower your credit score, leading to a higher mortgage rate and monthly payment. Additionally, certain mortgage programs may become inaccessible if your credit score falls below a certain threshold. The approval guidelines for collection accounts vary depending on the loan program, and it is essential to understand how your collection accounts will affect your eligibility for a mortgage.

Credit score impact

A collection account can impact your credit score in several ways. Firstly, having an account in collections can cause your credit score to decrease. A lower credit score can make it more challenging to qualify for a mortgage, as it may lead to a higher mortgage rate and monthly payment. If your credit score is too low, you may not meet the eligibility criteria for certain mortgage programs. Therefore, it is advisable to check your credit score in advance and address any negative issues, such as collection accounts, to improve your chances of mortgage approval.

The impact of a collection account on your credit score also depends on its type and age. For instance, medical collections and non-mortgage-related charge-offs are generally not counted against you and do not impact your eligibility. On the other hand, collection accounts for other types of debt, such as credit card debt, can have a more significant impact on your credit score. Additionally, older collection accounts may have a lesser impact on your credit score than more recent ones. Paying off an old collection account can sometimes lead to a short-term dip in your credit score, as it becomes a recent delinquent account.

To mitigate the impact of collection accounts on your credit score, it is recommended to proactively address the issue. This can be done by reaching out to the collection agency and establishing a payment plan. While paying off the debt in full is ideal, it is not always necessary for loan approval. By proactively addressing the issue, you can boost your credit score and improve your chances of getting approved for a mortgage.

It is also important to note that lenders consider various factors beyond your credit score when evaluating your mortgage application. These factors include your debt-to-income ratio (DTI), the type of debt you have, and your ability to make regular payments. Lenders may have different requirements and caps for DTI ratios and derogatory credit, so it is essential to understand their specific criteria.

Debt-to-income ratio

Your debt-to-income (DTI) ratio is a key factor in mortgage approval. It represents the percentage of income you have left after making monthly debt payments. The lower your DTI, the better your chances of approval and the better the interest rate you'll be offered.

Lenders will review your DTI ratio to determine how much mortgage you can afford. They'll look at your major monthly debts, including student loan payments, car loans, and the new mortgage payment. They may also include expenses that don't show up on your credit reports, like childcare, child support, or alimony. Lenders typically focus on two types of DTI ratios:

• Front-end ratio or housing ratio: This shows what percentage of your income would go toward housing expenses if you were approved for your mortgage. It includes your monthly mortgage payment (principal and interest), property taxes, homeowners insurance, mortgage insurance, and homeowners association fees, if applicable. Lenders generally look for a front-end ratio of no more than 28%.
• Back-end ratio: This shows how much of your income is required to pay all your monthly debt obligations. For conventional purchase loans, the average back-end DTI ratio was 34% in December, according to Ellie Mae. For VA loans, it was 39%, and for FHA purchases, it was 47%. Most lenders see DTI ratios of 36% or below as ideal, with approval above 50% being difficult to achieve.

Lenders don't usually factor collections and charge-offs into your DTI ratio unless you're actively paying them off. If you're making payments, the lender may include the payment in your DTI ratio, reducing the mortgage amount you can afford. However, it's better to address these issues than to ignore them. If you can show a history of on-time payments, some lenders will essentially ignore a collection.

DTI ratio doesn't tell the full story of mortgage affordability. Lenders will also consider your credit score, stable earnings, and payment history. They'll want to know what type of debt you have, how much you owe, and whether you're making regular payments. They'll also look at your compensating factors, such as savings or assets.

To improve your chances of mortgage approval, you can lower your DTI ratio by reducing your debt or increasing your income. You can also save a larger down payment, which will make your application more favourable and lower your monthly payments.

FHA mortgage requirements

When it comes to FHA mortgage requirements, your income, savings, and credit history are all taken into account. Collections, charge-offs, and judgments on your credit report can negatively impact your chances of approval. A collection occurs when you don't pay a bill, such as a medical or credit card bill, and the creditor sells the debt to a collection agency. This results in a "collection account" on your credit report, which can lower your credit score and make lenders wary of offering you a loan.

The Federal Housing Administration (FHA) has specific guidelines on how these financial issues are treated, and understanding these guidelines is crucial for successfully navigating the FHA loan application process. While the FHA does not require collections to be paid off entirely for borrower approval, they do recognize that collections can impact a borrower's ability to repay their loan. Non-medical collections are considered more carefully than medical ones, and may impact your FHA loan eligibility.

Charge-offs occur when a creditor decides you are unlikely to pay back a debt, and they declare it a loss. This is a negative mark on your credit report, indicating that you failed to repay a debt as agreed. While the FHA has more lenient views on charge-offs compared to other credit issues, they can still impact your overall creditworthiness. Lenders may require an explanation and supporting documentation for charge-off accounts.

To improve your chances of FHA loan approval, it is recommended to work with a loan officer or broker experienced in FHA loans. Resolving unpaid debts and improving your credit score can also increase your chances of approval. Understanding the FHA guidelines and your own financial standing is key to successfully managing your credit and working towards better financial health.

Loan approval timing

The loan approval process can be a lengthy one, and the timing varies depending on the circumstances. Here are some key factors that influence the timing of loan approval:

Credit History and Disputes

It is recommended to check your credit report several months in advance of applying for a mortgage. This allows time to address any negative issues, such as collection accounts, and work on improving your credit score. It is important to remove all disputed items from your credit report before submitting your application to an underwriter. Disputes can be removed by contacting the entity that placed the complaints or by reaching out to credit agencies directly.

Debt-to-Income Ratio (DTI)

Lenders use your credit report to calculate your debt-to-income ratio (DTI), which is an important factor in determining your ability to afford regular payments. Most lenders prefer a DTI below 43%, and a lower DTI can increase your chances of timely loan approval.

Type of Loan and Lender

The type of loan and the specific lender you choose can impact the approval timing. For example, certain loans like FHA or USDA mortgages have their own guidelines and requirements that may extend or shorten the approval process. Additionally, some lenders may be more flexible with their eligibility criteria, such as allowing a certain amount of non-medical collections.

Underwriting and Final Approval

Once your loan application reaches the underwriting stage, the underwriter will review all the conditions and issue the Clear to Close (CTC) if everything meets the guidelines. The closing department will then send the loan instructions to the title company, which will prepare the final Closing Disclosure (CD). The final CD typically becomes available a day or two before closing.

Funding

For purchases, funding typically occurs within an hour or two after all parties have signed. For refinances, there is usually a three-day recession period before funding, unless it involves a second home or investment property, in which case funding may occur on the same day as closing.

It's important to remember that these are general guidelines, and the specific timing of loan approval can vary depending on individual circumstances and the lending institution.

Medical collections

Medical debt has become one of the most common reasons homeowners face challenges when seeking mortgage approval. It can affect the mortgage approval process in two ways. Firstly, unpaid medical bills can sometimes inflate your debt-to-income ratio. Lenders use this ratio to determine how much home you can afford without falling behind on payments. Secondly, medical debt can appear on your consumer report, which can hurt your credit score.

However, this does not mean that unpaid medical collections will prevent you from getting a mortgage. In 2021, FICO released FICO 9, a new credit scoring model that disregards all paid collection accounts and gives less weight to unpaid medical collections. If your lender uses FICO 9 or the VantageScore 3 scoring model, paid or settled collection accounts won't affect your credit score. Additionally, FHA-backed mortgages have eliminated medical debt from consideration when evaluating a borrower's creditworthiness.

It is important to note that not all unpaid medical bills go to collections, and not all collections are reported to credit bureaus. As of July 2022, paid medical debts no longer count against your credit score. If you meet the lender's other eligibility requirements, such as a strong payment history, a great credit score, a healthy down payment, and sufficient income, your delinquent medical bills may not significantly impact your mortgage approval.

Before shopping for a mortgage, it is recommended to pull your free annual credit reports to understand your financial standing better. If you find medical collections on your report, ensure that you owe the debt, as it is not uncommon for consumers to be incorrectly charged. Disputing any incorrect debts is crucial, especially if your insurer is responsible for covering those medical expenses. However, be cautious not to reactivate or restart the debt clock by making promises or partial payments to collectors.

Additionally, consider shopping around for lenders with favourable rates and lending policies. Ask about overlays and whether they use the latest FICO scoring models, such as FICO 9, which treats medical debt more leniently.

Frequently asked questions