Can You Buy a House with Collections?

Collections — the process of pressing a borrower to repay money owed to a business or organization — can present a thorny patch in the road to your financial goals. The good news is, that collections are only a patch, not a blockade.

You can get through. It absolutely is possible to buy a house while burdened by collections, even if that means needing to qualify for a mortgage.

Having complications in your credit report will complicate the process. But you can still get approved. It all depends on the lender, the type and amount of debt you’re carrying, and the sort of mortgage for which you’re applying.

“Focus on resolving recent or high dollar collections,” says Steven Parangi, a manager at Rochelle Park, N.J.-based Alpine Mortgage Services. “Even partial payments or payment plans show lenders you’re taking responsibility.”

How Do Collections Impact Buying a House?

First, the good news: Your credit doesn’t have to be pristine, perfect, and utterly above reproach to qualify for a mortgage. Mortgage lenders and their dedicated underwriters expect their applicants to have a certain amount of debt. They simply prefer modest debt, well-managed and current.

Debts that have lapsed sufficiently to tumble into collections present a challenge to the prospective lender and borrower alike. Collections hoist caution flags for the lender, indicating the applicant may be a significant risk for repayment.

“Mortgage lenders don’t want to loan money to people who have a seemingly lower likelihood of making their payments,” says Adam Hamilton, CEO of REI Hub in Prince Frederick, Md. “The presence of collections in and of itself is something mortgage lenders consider as well. It also contributes to how risky the prospective borrower appears to be.”

Lenders have ways of mitigating risk, Hamilton adds: “Even if a person with collections gets approved for a mortgage, their interest rate will generally be higher in order for lenders to attempt to better protect themselves.”

Debt to Income Ratio

While lenders use assorted metrics to gauge an applicant’s financial trustworthiness, the keystone measurement is your debt-to-income ratio. That is, how much you have going out vs. how much you have coming in.

Lenders measure debt-to-income (DTI) in two ways, front end (also called the housing ratio and the mortgage-rate ratio) and back end (total debt ratio). Each is expressed in percentages.

The front-end ratio measures the percentage of your monthly gross income (the amount before taxes and other deductions) that would go toward housing expenses (mortgage payment, property taxes, homeowners insurance, homeowners association dues). Typically, lenders prefer a front-end ratio of no higher than 28%.

The back-end ratio calculates the weight of all your monthly expenses (housing costs, credit card payments, car loans, child support, student loans, and all other revolving debt on your credit report) vs. gross income. Your target: 36% or lower.

Breach either of these target ratios, and your prospective lender may decide you have too much debt to approve the loan.

Interestingly, if you have collections or charge-offs on your credit report, you may take a hit on your credit score, but they won’t be part of your DTI calculation (more about that in a moment) … unless you are making regular monthly payments on those debts.

Derogatory Credit

Derogatory credit covers a lot of ground, including collections, charge-offs, judgments, and liens. Lenders may proceed with loan approvals despite collections and charge-offs (more about that in a moment), but tax liens and civil judgments must be resolved.

Applicants with tax liens may be able to get to closing if there’s an established payment plan accompanied by a history of at least 12 months of timely payments.

How to Deal with Collections When Applying for a Mortgage

There’s no one-size-fits-all solution for managing collections while attempting to qualify for a mortgage. Much depends on the size, age, and condition of the account(s) in collections.

For those hoping to improve their credit score ahead of making an application, payment plans may be prudent — with a caveat: When dealing with debt collectors, ask them to erase this black mark from your credit report.

If you’re already in a payment plan, or you have paid-off collections lingering on your credit history, alert the collector that it can expect a goodwill letter from you, then follow up. The goodwill letter will be a request for the creditor to remove the stain from your credit report. Anecdotal evidence suggests these requests for kindness occasionally work.

Old Collections

Step One when you receive your trio of free credit reports: Review them for accuracy on old collections. Compare them to your records. Is the collection legitimate? Is the amount owed accurate? If there are mistakes, ask the reporting agencies to correct the error(s), or remove them from your account.

If the information in your report proves accurate, you have decisions to make. Curiously, because it makes an old collection new again, merely paying off old collections can harm your credit score. Instead, proceed with caution.

“Don’t just pay off the collections,” says San Antonio, Texas-based Matt Schwartz, founder of VA Loan Network. “Whether paid or unpaid, [collections] have the same negative impact on your credit. Typically, you want to pay off the collections only if they agree to accept payment for deletion.”

This is delicate territory. If you’re already in the mortgage application process, do not discuss old collections with creditors. The clock on the old debt will reset.

Instead, in writing, ask the creditor to provide documentation that you owe the debt and that they are the authorized collector. State clearly in your letter that you do not acknowledge the debt. If the creditor fails to provide documentation, dispute the account with the credit bureaus. Furthermore, if the old debt is reported as new, you can have it removed as a violation of the Fair Credit Reporting Act.

The impact collections have on your credit score diminishes over time.

Check the Statute of Limitations

Collections can remain on your credit report for up to seven years. However, many states limit how long creditors can pursue consumers for bad debts, typically 3-6 years.

The factors that play a role in the collections statute of limitations include the type of debt; the state you live in; and the state law identified in your credit agreement.

When the statute of limitations period starts can vary. In some states, the starting line is the date when the first required payment was missed. In others, it’s when the most recent payment was made.

It’s in your interest to know the rules for your state.

New Collections

Accounts that only recently have fallen into collections can be subject to negotiations. Once you ascertain the debt is legitimate, discuss suitable payoff terms with the creditor or collection agency. When paying collections, insist on written documentation: Make sure about the total amount you will be paying, the number of payments involved, the date they’re due, whether collection fees or interest are included, and what happens at the end of the payment term. Make certain the terms fit within your budget framework. Again, argue for having the account deleted from your credit report.

Medical Collections

Medical collections accounts get different treatment from non-medical collections. They’re excluded from your DTI calculations.

Additionally, the Consumer Financial Protection Bureau erased medical debt from credit score calculations.

Student Loan Collections

Federal student loans, no matter what type, cannot be discharged, even in bankruptcy. Applicants who have defaulted on federal student loans will not be approved for FHA-backed mortgages.

If your federal student loan is blocking the path to mortgage approval, explore your options, including loan consolidation.

How Collections Impact Different Mortgage Loans

The mortgage industry is vast, providing a wide variety of options for prospective homeowners. The dedicated mortgage shopper, even one with a bruised credit score and collections clinging like barnacles to his/her history, may find something suitable.

Here’s a quick peek at the mortgage-option terrain for the collections-burdened home-seeker.

• Conventional mortgage, single-unit primary residence: You are not legally bound to pay off or establish a payment plan, although your lender of choice may require it. Typically, a collections account will not affect your ability to qualify.
• Conventional mortgage, 2–4-unit primary residence or second home: Collections accounts totaling more than $5,000 must be paid off in full.
• Conventional mortgage, rental property: Individual collections accounts with a balance of at least $250 and accounts with a combined balance greater than $1,000 must be paid in full before your loan can close.
• Jumbo mortgage: Guidelines for jumbo mortgages tend to be less standardized and vary by lender. Check with prospective lenders in advance.
• VA home loan: VA Program guidelines regarding collections hinge on the number of accounts and other factors. Applicants with one or two accounts in collections but who otherwise have good credit and payment histories, get better treatment than applicants with problematic credit profiles and histories of multiple collections accounts. Checking with a variety of VA lenders for terms and conditions is always a good plan.
• FHA mortgage, standard underwriting: For collections accounts totaling $2,000 or more, the applicant must either pay off the account balance in full or establish a payment plan. As noted above, medical account collections are excluded from your total account balance. Monthly payment plans are folded into the applicant’s DTI Can’t agree on a repayment plan? The lender includes a monthly debt payment equal to 5% of the collection account balance in your DTI ratio. If your outstanding collection account balance is $2,000, the lender adds $100 to your debt-to-income ratio ($2,000 * 5% = $100).
• FHA mortgage, manual underwriting: Loan applications requiring an exception to FHA qualification requirements (a low credit score or high DTI ratio or accounts in collections, for instance) are subject to a comprehensive review of your application, known as manual underwriting. If collections are part of the equation, the lender must provide documentation explaining why your application should be approved. The lender also must review what caused the account to enter c The applicant must submit a letter explaining each collection account, including why the issue occurred and the steps taken to resolve it. The decision to approve then rests with the underwriter.
• USDA home loan, standard underwriting: The collection account guidelines for a USDA home loan match those of an FHA mortgage.
• USDA home loan, manual underwriting: Again, USDA requirements match those of an FHA mortgage application.

Applicants needing manual underwriting cannot afford to be in a hurry. The process takes time, effort, and substantially more documentation from both the lender and the applicant. Also, not all lenders work with applicants needing manual underwriting; you may need to contact multiple lenders to find one that does.

Speak to a Credit Counselor Before Applying for a Mortgage

With decades of experience in the mortgage industry, Michael Branson’s foremost advice for those with troubled credit histories comes down to this: Have patience.

“If you can’t qualify for a mortgage on your own, it’s a possible sign that you’re not ready for it,” says Branson, CEO at Orange, Calif.-based All Reverse Mortgage. “A mortgage is a long-term financial responsibility/commitment. So don’t just jump into it without being completely ready.

“Take a step back and focus on improving your credit, building up your savings, and lowering any debts. It’s better to wait a little longer and be fully prepared than to rush into something that could cause you a lot of financial stress down the road.”

As we have discussed at length, it’s possible to qualify for a mortgage with collections on your record. But it’s complicated and potentially expensive. If Branson’s advice is the tough love you need, and improving your financial health is your newfound goal, start taking steps today to get you where you want to be.

Begin by recruiting a fresh set of eyes. Credit counselors are experts in personal finance; their training and experience enable them to spot problems and offer solutions that can set you on the road to excellent financial health, preparing you for the mortgage application experience of your dreams.