Buying a Home After Bankruptcy, and Other Mortgage FAQs

Every year, we receive hundreds of questions from home buyers and mortgage shoppers. We recently compiled all of the questions from 2010 to identify trends. The second most common question came from people who filed bankruptcy. (The most common FAQ was related to credit scores needed for a mortgage).

The bankruptcy folks wanted to know the following:

Is it possible to buy a home after a bankruptcy filing? And if so, what steps do I need to take? How long do I have to wait after bankruptcy before I can get approved for another mortgage loan? Is it easier to get an FHA loan under these circumstances? You'll find answers to all of these questions below.

Short Answer: Yes, You Can Buy a Home after Bankruptcy

Let's start with the short answer and build from there. Yes, it's possible to get approved for a mortgage loan after a bankruptcy filing. Depending on the type of filing (Chapter 7 vs. Chapter 13) and other factors, you may have to wait anywhere from one to four years before you can get another mortgage loan.

Additionally, there are things you can do now to improve your chances of buying a home later on. These include reducing your debt, rebuilding your credit, and saving money. We will discuss all of these things in more detail as we move through the lesson.

1.5 Million Bankruptcy Filings in 2010

According to the American Bankruptcy Institute, 1.5 million consumers filed some form of bankruptcy in 2010. This marks a 9% increase over 2009. In the two years before 2009, bankruptcy filings increased by double-digit percentages. This explains why we get so many questions about buying a home after bankruptcy. Their ranks have grown! 

I probably don't need to tell you why the numbers have risen so much -- foreclosure crisis, economic recession, soaring unemployment rates, etc. Just know this. If you are trying to get approved for a mortgage loan after bankruptcy, you are certainly not alone. As a result of the high numbers of bankruptcy filings, mortgage lenders are more willing to consider extenuating circumstances today than they were in the past.

We will revisit the topic of extenuating circumstances below.

Difference Between Chapter 7 and Chapter 13

Let's discuss the differences between Chapter 7 and Chapter 13 bankruptcy filing. It's important to understand the difference, because it may dictate how long you have to wait after bankruptcy to get another mortgage loan.

Chapter 7 and Chapter 13 are the two most common types of bankruptcy filing among consumers. The main difference between them is how the debts are handled.

• With a Chapter 7 filing, the consumer is asking the courts to basically wipe the slate clean. They want their debt obligations to be discharged or "erased" by the court.
• With the chapter 13 filing, the consumer makes an effort to pay back some or all of the debt obligations. They do this through a court approved payment plan.

Based on these differences, you can probably guess which type of filing would hurt you the most. In general, buying a home after a chapter 13 bankruptcy is easier than with a Chapter 7 filing. That's because the consumer is taking responsible steps toward repaying the debt. As a result, they might not have to wait as long before qualifying for another mortgage loan.

Let's talk about the timeframes and other rules regarding mortgages after bankruptcy.

Bankruptcy Rules For Conventional Versus FHA Loans

A conventional mortgage loan is one that is not insured by the federal government. An FHA home loan is insured by the government, under the management of the Federal Housing Administration. How long you must wait after bankruptcy before getting another mortgage will largely depend on the type of loan you want.

In most cases, you'll have to wait longer to qualify for a conventional mortgage loan than an FHA loan. For this reason, buying a home after bankruptcy might be easier with an FHA loan. At the very least, you probably won't have to wait as long.

Here's how the current rules work:

Rules for Conventional Mortgage Loans

In this context, I'm talking about conforming conventional loans. These are mortgages that meet the minimum guidelines established by Freddie Mac and Fannie Mae. Most conventional loans fall into the "conforming" category these days.

If you want to qualify for a conventional mortgage loan after a Chapter 7 bankruptcy filing, you will probably have to wait at least four years. That is, if the loan conforms to the guidelines set by Freddie Mac and Fannie Mae. If you can document some extenuating circumstances that were beyond your control, you might be able to get a mortgage in as little as two years after the bankruptcy is discharged.

Note: these timeframes start after the bankruptcy is discharged, not when it is filed. The discharge might take place months after the filing.

To get a conventional mortgage loan after a Chapter 13 bankruptcy filing, you will probably have to wait at least two years after discharge -- or four years after dismissal. Here's the difference between these terms. Under a Chapter 13 filing, "discharge" means you are making an effort to pay back your debts. In other words, you are following the court-approved payment plan. "Dismissal" means you have failed to meet the repayment guidelines in some way. So it makes sense that a person who is repaying the debts should be able to get a mortgage sooner than someone who is not.

Rules for FHA Home Loans

For an FHA loan, the rules are slightly different (and more lenient). You might be able to qualify for a government-backed mortgage in as little as one year after the bankruptcy. That's why I said buying a home after bankruptcy was easier with an FHA home loan, as compared to a conventional mortgage. The waiting period is shorter, and there is generally more flexibility with regard to extenuating circumstances.

Here again, how long you must wait depends on the type of filing:

If you filed Chapter 7 bankruptcy, you may have to wait at least two years before you can qualify for an FHA loan. If you can document extenuating circumstances (described below), you might qualify after one year. In either scenario, you must show your ability to manage your finances. We will talk about what this means later on. In addition, you must either (A) restore your good credit or (B) avoid taking on any new credit obligations.

After a Chapter 13 filing, you could qualify for an FHA loan even sooner. It's possible to get approved during the payback period, as long as one year has passed. Your payment performance must be "satisfactory" as well. This means you are meeting the payment guidelines set forth under your court-ordered repayment plan. You must also get the court's approval to take on another mortgage loan after a Chapter 13 filing.

I've expressed these rules in my own words to help you understand them. But I want to include the actual source of these rules, just to make sure you're clear on how they work. Here's what the Federal Housing Administration and HUD have to say about buying a home after bankruptcy proceedings. I've added the yellow highlights for emphasis.

What are Extenuating Circumstances?

We've talked a lot about extenuating circumstances, and how they can help you buy a home sooner after bankruptcy. But what are these circumstances? How can you document them to support your case? Let's start with an official definition:

As far as Fannie Mae and Freddie Mac are concerned, extenuating circumstances are "nonrecurring events that are beyond the borrower's control that result in a sudden, significant, and prolonged reduction in income or a catastrophic increase in financial obligations."

But be warned. If you claim these types circumstances, you will have to back up your claim in some way. They're not just going to take your word on it. Mortgage lenders must verify that extenuating circumstances actually did exist, typically through the use of certain documents:

• Notice of job layoff
• Job severance letter
• Divorce decree
• Tax returns that show a loss of income
• Other documents that might support your claim

Again, the goal here is to show that you suffered from events that were largely beyond your control -- events that reduced your income or increased your expenses (or both). If you can do this, buying a home after bankruptcy might come sooner rather than latter.

It's Confusing, So Let's Summarize

I've thrown a lot of information at you, including several different scenarios for waiting periods. So let's sum up what we have discussed so far. First of all, there are exceptions to every rule. So I don't want you to view this information as been written in stone. It's written in clay. With that being said, there are certain guidelines that apply in most scenarios. Those are the rules we have been discussing thus far.

Here's a quick recap:

If you want to use a conventional mortgage loan (that is not backed by the government), you may have to wait two to four years before buying a home. With a Chapter 7 filing, the usual waiting period is four years. But this can be reduced to two years if there are extenuating circumstances. With a Chapter 13 filing, the waiting period is generally two years after discharge, or four years after dismissal.

For an FHA loan, you'll probably have to wait at least one to two years before buying a home. With a Chapter 7 filing, you could qualify within two years if you restore your credit and manage your finances well. You might be able to qualify after one year if you have extenuating circumstances. With a Chapter 13 filing, you could get an FHA loan after one year if you have kept up with your court-approved payment plan. You will also need the court's permission to enter into another mortgage obligation.

What You Can Do in the Meantime

If buying a home after bankruptcy is a top priority for you, then you've got work to do. The worst thing you can do is to sit around and do nothing. As we have seen, there are certain waiting periods before you can qualify for another mortgage loan. But there is plenty you can do in the meantime to improve your chances of getting approved.

Here are some of the goals should strive for:

• Pay all of your bills on time. This is crucial, because your payment history accounts for 35% of your FICO credit score. Restoring your credit will help you get approved for another loan after bankruptcy, and paying your debts on time is the best way to boost your score.
• Reduce your debt obligations as much as possible. If you have filed for bankruptcy in the past, the lender is going to view you as a larger potential risk. But you can support your cause by reducing your debt load. This will give you a more favorable debt-to-income ratio and help you qualify for a loan.
• If you filed Chapter 13 bankruptcy, you probably have a court-approved plan to repay some of your debts. The best thing you can do in this scenario is to make all of those payments on time. If you do this, you could qualify for an FHA loan after one year in the repayment program.
• If you have trouble managing your finances, consider taking a class on financial management. You might be able to get this training for free, if you use a HUD-approved housing counselor. Having this training under your belt could help you in two ways. It will show the mortgage lender that you are serious about improving your financial situation. It will also help you accomplish the other goals we discussed above.
• Save as much money as possible. It might be hard to save money while paying off your old debts, but it's well worth the effort. When buying a home after bankruptcy, borrowers often face additional requirements for cash reserves. You will need to have sufficient funds to cover your down payment, your closing costs, and probably your first few mortgage payments as well. So start a home-buying fund.

All of these things will help you when it comes time to apply for another mortgage loan. So they are all worth pursuing. As you read the section below, you'll realize why I recommended each of these steps.

General Mortgage Guidelines

In closing, I want to touch on some of the basic guidelines required to get a mortgage loan. This applies to people who are buying a house after bankruptcy as well as "regular" home buyers. In addition to the goals outlined above, you need to make sure you measure up in these areas as well.

Down Payments

Unless you're using a VA or USDA home loan, you will probably have to make a down payment of at least 3.5%. The FHA allows down payments as low as 3.5% if you have a credit score of 580 or higher. With a conventional mortgage loan, you will certainly need a down payment of at least 5% -- and probably more.

That's why I stress the importance of saving money early. If you're serious about buying a home after foreclosure, you should create a housing fund to cover your down payment, closing costs and cash reserves. Start today.

Credit Scores

Aside from the FHA program, it's extremely difficult to qualify for a mortgage loan with a credit score below 620. This wasn't an issue during the housing boom, when they were giving mortgage loans to anyone with a pulse. But a lot has changed since then.

Your credit score will certainly take a plunge after a bankruptcy filing. And it can stay on your credit report for up to 10 years. But the negative effect it has on your score will actually diminish over time. So there are certain things you can do to improve your score in the meantime. This will also help you get approved for a home loan, after the waiting periods we discussed earlier.

Debt Ratios

Mortgage lenders are also stricter about debt-to-income ratios. This is a comparison between the amount of money you make each month, and the amount you spend to cover all of your debt obligations. For example, if half of your monthly income goes toward your debt payments, then you have a 50% debt-to-income ratio or DTI. This is fairly high, and it will hurt your chances of getting approved for a mortgage loan. If you can get your ratio to 35% or lower, you'll be much better off when it comes time to apply for a mortgage.

Buying a home after bankruptcy is certainly possible. But there are certain steps you must take to restore your credit, and to prove your financial responsibility. Depending on the nature of your bankruptcy filing, and the type of mortgage loan you use, you could get approved for another loan in one to four years. If you can document extenuating circumstances, the waiting period will be shorter. Likewise, you can shorten the waiting period by rebuilding your credit score.