Being bankrupt is scary. And Americans have all been afraid of it since we played Monopoly as kids. But it doesn’t need to be scary. In reality, at least 800,000 Americans file for bankruptcy every year. And undoubtedly many of those people are good, hard-working folks that just hit a speed bump in their lives. In 2020, Covid-19 is already having the same unexpected impact on many people too.
Types of bankruptcy – Chapter 7 and Chapter 13
There are two ways to file, if you’re heading into bankruptcy, Chapter 7 bankruptcy and Chapter 13 bankruptcy.
Chapter 7 – The most common type of bankruptcy is Chapter 7. During a Chapter 7 bankruptcy, a court wipes away your obligation to pay back qualifying, unsecured debts – think credit cards, medical bills, or loans extended without collateral. Unfortunately, your credit report will also take a major hit.
Chapter 13 – With Chapter 13 bankruptcy, you have to pay back your debt. However, the debt is reorganized and a repayment schedule to your creditors is established that makes monthly payments on time more affordable. Chapter 13 doesn’t have as large of an effect on your credit score, and you can keep your assets.
How long do you need to wait to buy a home?
If you’ve filed for Chapter 7 bankruptcy, you need to wait at least 4 years after a court discharges or dismisses your bankruptcy to qualify for a conventional loan to buy a home.
The amount of time you need to wait to apply for a conventional loan after a Chapter 13 bankruptcy depends on how a court chooses to handle your bankruptcy. If the court dismisses your bankruptcy, you must wait at least 4 years from your dismissal date, before you can apply. If a court discharges your bankruptcy, the waiting period is 4 years from the date you filed and 2 years from your dismissal date.
Typically, there are different waiting periods for different kinds of mortgage loans:
- Conventional mortgage loans – These have the longest waiting period. You will need to wait two years following a Chapter 13 bankruptcy, and four years following a Chapter 7 bankruptcy.
- FHA mortgage loans – Federal Housing Administration (FHA) loans are open to most qualified borrowers, regardless of income, age or homeownership experience, and they require a minimum of 3.5% down. They are designed for low to moderate income borrowers with lower credit scores than conventional loans. You will need to wait one year after a Chapter 13 bankruptcy, and two years following a Chapter 7 bankruptcy to qualify for an FHA loan.
- VA mortgage loans – Veteran’s Affairs (VA) loans are open to military service members, veterans and their families and require a minimum of 0% down. The VA loan program was originally created in 1944, part of the GI Bill of Rights for returning servicemen from WWII. You will need to wait one year after a Chapter 13 bankruptcy, and two years following a Chapter 7 bankruptcy to qualify for a VA loan.
- USDA mortgage loans – US Department of Agriculture (USDA) loans are open to rural home buyers with income no higher than 115% of the adjusted area median income, which varies by county. These loans also require a minimum of 0% down. Uniquely, USDA Loans offer 100% financing to qualified buyers, and allow for all closing costs to be either paid for by the seller or financed into the loan. You will need to wait one year after a Chapter 13 bankruptcy, and three years following a Chapter 7 discharge.
How do you apply for a mortgage loan after bankruptcy?
Rebuild Your Credit
Since a bankruptcy on your credit report lowers your credit score, it will be difficult but still possible to get a mortgage loan. However, you still must meet your lender’s minimum credit score requirements. You’ll probably need some time to repair your score before you can apply for a loan, if you have a credit score of 580 points or lower.
- Re-establish your credit – Get a secured credit card. When you open a secured credit card, you put a deposit down with your credit card company. This deposit becomes your line of credit. From there, you make payments on your account and pay off your debt each month. You can get a secured credit card with a low credit score, even after a bankruptcy.
- Pay down your debt – Put any extra cash you have toward paying down debt after your bankruptcy closes. This shows creditors that you’re serious about making a change in your financial situation and raising your credit score over time. Lower levels of debt can also help you qualify for a mortgage.
- Pay all your bills on time – The fastest and easiest way to raise your credit score is to make your credit card and loan payments on schedule each month. Sign up for auto-pay where you’re able, if you have trouble managing your payment due dates. Most credit card and loan companies have an auto-pay feature that automatically deducts your minimum payment on the day it’s due.
Write A Letter Of Explanation
Your lender takes a careful look at your finances when you apply for a mortgage. Lenders need to know that you’ll make your payments on time every month. Of course, a bankruptcy on your record is a big deal, since every lender is taking a risk by working with you.
You can increase your chances of getting a mortgage after bankruptcy by writing a letter of explanation. A letter of explanation tells your lender more details about your bankruptcy and why you needed to declare bankruptcy. And how your financial life has changed since then. Also, explain the steps you’ve taken to prevent a future bankruptcy too.
A letter of explanation isn’t a requirement to get a mortgage after bankruptcy, but it can help your lender see the bigger picture instead of just a set of numbers. Include your letter of explanation with your mortgage application when you request a pre-approval.
Once you’ve gone through your waiting period and your finances are in order, it’s time to apply for a mortgage pre-approval.
Basic documentation – You will need your driver’s license, Social Security number, and any other pertinent proof of identity (such as a marriage license, if your name has recently changed).
Proof of income – This can take the form of W-2s, pay stubs, bank records, and sometimes written proof of income from your employer. If you receive alimony, child support, significant investment dividends or any other type of income. You will want to have proof of these resources as well. If your income is verifiable and can count toward the purchase of a home, be prepared to provide proof. It is standard for a lender to ask for two years of proof of income to get you pre-approved.
Proof of assets – Conventional financing will require a 10-20% down payment, while FHA financing requires a down payment as low as 3.5% of the purchase price. You’ll need to provide proof of enough funds to cover the down payment, closing costs and cash reserves equal to two months of expenses, typically.