Contrary to popular opinion, you don't have to pay off your open collection accounts to get approved for a mortgage. In fact, the Federal Housing Authority (FHA) does not require applicants to zero out collection debts to participate in their loan guarantee program. However, just because you can still get approved for a home loan doesn't mean it will be easy. Here's what you need to know to increase your chances of obtaining financing for the home you want to buy.
Debts Must Meet FHA Requirements
The FHA won't hold your collection accounts against you, but they must meet certain conditions before the agency will agree to guarantee your loan. For debts that total $2,000 or more, you must make payment arrangements with the creditor and furnish proof of it to the bank. The bank must then include the debt when calculating your debt-to-income (DTI) ratio.
You have to be careful here, because the payments you agree to make on your debt can push your DTI too high, and you could get denied because of that. The maximum DTI you can have and still be covered by FHA is 31 percent on housing and 43 percent total. If the payments you agree to make to the creditors pushes your ratio higher than that, you may be required to meet additional requirements to be approved, or you may be denied the loan.
It's essential that you calculate your DTI and either negotiate with the creditors so your payments keep you under the limit or pay off as much as much of the debt as is necessary to keep it at the acceptable level.
It's important to note that even if you don't make payment arrangements with your creditors, FHA still requires the bank to take the debt into account. The bank will treat the collection debt as though you will pay it and will calculate your potential monthly payments at 5 percent of the balance (e.g. $100 on a $2,000 debt). The resulting amount will be included with your DTI percentage.
This could potentially be disastrous, as the payment the bank comes up with may be much higher than you could negotiate with the creditor. Thus, it may be better to make payment arrangements for the debt than to let your potential lender factor it in according to FHA rules.
You May Need a Good Excuse for the Debt
FHA only guarantees loans, meaning the agency will pay the lender any balance due if you default on your mortgage. While lenders will be more lenient towards FHA-qualified borrowers when it comes to qualifying them for loans, they still have minimum requirements applicants must meet that are often more stringent than the FHA's conditions. So, although the FHA may not mind that you have collection accounts, potential lenders may care very much because it's seen as an indicator of how you handle your finances.
Some lenders will reject your application once they see those collection accounts. However, others may manually process and approve your loan if you can provide them with a good explanation as to how those collection accounts came about. For instance, if the collection accounts are because of medical debt, a lender may be willing to go through with the loan, since the debt likely represents extenuating circumstances that probably won't repeat in the future.
You'll need to talk to your case manager about how the lender handles collection accounts. If the bank will let you submit a personal statement about the debt, take advantage of that to increase your chances of being approved. Be prepared to submit any supporting documentation, though.
For more information about this or other issues related to getting approved for an FHA mortgage, contact a company like NRL Mortgage LLC.