do you have to pay off collections to get a mortgage

Do You Have to Pay Off Collections to Get a Mortgage?

Getting approved for a mortgage when you have collections on your credit report is a common concern for homebuyers. With buying a house being such a major investment, it’s natural to worry about how past financial issues could impact your ability to get a home loan. The good news is, having collections doesn’t automatically disqualify you from mortgage financing. However, navigating lenders’ guidelines on collections requires some strategic planning.

In this comprehensive guide, we’ll explore whether you need to pay off collections to get a mortgage, as well as how to boost your chances of approval even with this credit challenge.

What Are Collections and How Do They Affect Your Credit?

Before we get into the rules for mortgages, let’s quickly go over what collections are and how they can hurt your credit. When you don’t pay a debt on time and the creditor hires a collection agency to get the money back, this is called a collection account. Credit cards, medical bills, personal loans, utility bills, and other types of debt often end up in collections.

There is a bad mark on your credit report when an account goes into collections. This hurts your credit score because it shows that you have missed payments and are having trouble handling your debt. Lenders see you as a higher credit risk if you have collections on your record.

It doesn’t hurt your credit as much if the collection is old and the amount is small. Lenders are more worried, though, about recent collections or large balances that haven’t been paid. Overall, collections make getting any type of financing more challenging. For those who know the rules and follow them, however, getting a mortgage is possible.

FHA Guidelines on Collections – Do They Need to Be Paid Off?

When trying to get a mortgage with collections, FHA loans offer more flexible options than conventional loans. Here are the key FHA requirements to know:

• No Mandatory Payoff of Collections: The FHA does not require you to pay off collections prior to closing on your mortgage. This only applies to collections – any outstanding judgments or tax liens must be paid.

• Medical Collections Excluded from DTI: Any medical collections are omitted from your debt-to-income calculations, so they have no impact on your mortgage eligibility. Only non-medical collections may count.

• Payments on Collections Not Included in DTI Unless Being Made: If you are not making regular monthly payments on collections, they are not factored into your DTI. But if you set up repayment plans, these new monthly payments would count.

• Payment Options for Large Collection Balances: If you owe more than $2,000 in non-medical collections, the lender will use 5% of that amount to figure out your DTI, which could make it too high. To make up for this, you can show proof of a payment plan with a lower monthly payment.

The bottom line is with an FHA loan, you do not have to pay off collections before closing. Doing so can help strengthen your case but is not mandatory if following standard FHA underwriting.

Conventional Loan Options for Buyers with Collections

While more stringent than FHA, conventional loans can still be an option if you have collections reporting on your credit report. Here’s an overview:

• No Specific Payoff Requirement But May Be Needed: Conventional loans handled by Fannie Mae or Freddie Mac do not expressly require paying off collections prior to closing. But each lender sets its own requirements, so many may require payoff.

• Underwriting Rules Vary by Loan Type: For a primary residence conventional loan, collections policies are most flexible. Second homes or investment properties often have more rigid standards that may necessitate paying collections.

• Disputed Collections May Not Be Counted: If you dispute the accuracy or validity of a collection account, providing documentation can sometimes prevent a lender from including it as a condition for mortgage approval.

Overall, qualifying for a conventional loan with collections takes a very strong credit profile outside of the derogatory marks. Expect to provide significant documentation and possibly pay off part or all collections depending on the lender.

Should You Pay Off Collections Before Applying for a Mortgage?

Since paying off collections is not always mandatory, this raises the logical question of whether you should voluntarily pay them before applying for a mortgage. Here are some key factors to weigh when deciding:

• Will It Improve Your Credit Score? Paying off collections can potentially give your credit score a nice boost, especially if they are recent. However, score improvement is not guaranteed and needs to be weighed against the cost of paying collections.

• How Much Will It Cost You? Is the amount you would pay reasonable based on your financial situation? Paying off small balances may be simple but larger amounts could be a big hit. Make sure it makes sense for your budget.

• How Old Are the Collections? If they are several years old, paying them off will not provide as much of a score benefit. The impact lessens over time so older collections are often best left alone.

• Are There Inaccuracies? Double check for any errors in reporting. If collections are inaccurate or lack proper documentation, you may be better off disputing them rather than paying.

Consulting with a credit expert can help analyze if paying off collections prior to your mortgage application would be beneficial or not. In some cases, it can really help push your approval chances over the top while other times it may not be worth the trouble or expense.

Tips for Getting a Mortgage Approval with Collection Accounts

While you don’t always need to pay off collections, having them still presents challenges when qualifying for a mortgage. Here are some tips to boost your odds of approval:

• Shop Multiple Lenders – Guidelines vary, so talk to several lenders to find one comfortable with your specific credit situation. Local banks and credit unions may offer more flexibility.

• Get Prequalified First – Going through prequalification allows you to confirm a lender is willing to work with your collections before you formally apply.

• Highlight Your Positive Credit – Emphasize your more recent on-time payments, low balances on other accounts, and any positive credit you have.

• Explain Past Issues – Provide context on what caused the collections, how you’ve addressed underlying issues, and steps you’ve taken to manage credit.

• Pay Down Other Debts – Reducing balances on your revolving accounts helps lower your DTI and compensate for the collections.

• Build Savings – Having ample reserves makes lenders feel better about approving you with past credit challenges. Shoot for 6-12 months of mortgage payments in the bank.

• Get Credit Counseling – Consult with a nonprofit credit counseling agency for custom advice on improving your credit profile prior to mortgage application.

With the right lender and smart preparation, you can get mortgage approval even with collections reporting. The key is understanding guidelines, highlighting your strengths, and taking a proactive approach well in advance of applying.

How to Handle Collections If They Arrive During the Mortgage Process

A final scenario to discuss – what if collections show up on your credit report after you’ve already applied and been approved for a mortgage? This could threaten your approval, so quick action is required. Here are some options:

• Pay Off the Collections Immediately – If possible based on the balance, paying off the collections can stop them from hurting your credit further. Get proof of payoff.

• Dispute Inaccurate Information – If you have grounds to dispute the collections based on improper reporting or lack of ownership of the debt, start the process ASAP.

• Provide an Explanation – Draft a letter explaining the circumstances and reasoning for the new collections appearance. Emphasize steps you are taking to resolve the situation.

• Request Rapid Rescoring – Some lenders can re-run your credit after collections payoff or dispute to enable your mortgage to keep moving forward.

• Delay Closing Date – If you need time to deal with the collections, asking your lender for a closing date extension of 30-60 days can allow you time to improve your credit score.

• Change to FHA Loan – Switching to an FHA loan may provide more leniency if new collections have you no longer meeting conventional guidelines.

The best prevention, however, is maintaining a steady credit profile throughout the entire mortgage transaction. Avoid new credit applications, large purchases that require financing, or missed payments on existing accounts. Stability is key!

The Bottom Line – It Is Possible to Get a Mortgage with Collections

While collections make qualifying more challenging, homeowners should not lose hope. Understanding lender guidelines and taking the right strategic steps can still make homeownership possible. An experienced mortgage professional who knows how to position your application positively despite credit dings can also make a big difference.

The most important thing is being fully informed on how collections impact the mortgage process and having reasonable expectations. With planning and perseverance, your dream of owning a home can survive a few collections on your credit report. Maintain focus on the big picture and don’t let past setbacks stop you from building a bright future.