For the most part, we are a forgiving society. We believe that people often learn from their mistakes, and everybody deserves a second chance. Our mortgage system incorporates some of that philosophy — up to a point.
The two largest mistakes of consumers that challenge the capacity of the mortgage system to forgive are bankruptcy and foreclosure. Both are recorded in the borrower’s credit file and stay there for an extended period: Mortgage foreclosure and Chapter 13 bankruptcy remain for seven years, and Chapter 7 bankruptcy for 10 years.
Both cause an immediate and sharp reduction in the borrower’s credit score. However, because the scoring system weights new information more heavily than old information, it is inherently forgiving of past misdeeds, provided that the new information generated by the borrower is favorable.
But lenders have a longer memory than credit scorers, and they set minimum time periods for "forgiveness," independently of and without regard for credit scores. I recently received a letter from a prospective borrower with a credit score of 750 (same as mine) who had been discharged from Chapter 7 bankruptcy three years earlier.
She had used the three years to rebuild her credit. The reason she wrote me was that, despite her good score, she was being turned down for a mortgage.
About 95 percent of all mortgages being written today are sold to Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration (FHA). These agencies set the rules that lenders implement. However, lenders can be tougher than the agencies and many are because they don’t want high default rates on the loans they originate.
Fannie Mae requires the following waiting periods before a borrower becomes eligible for a mortgage the agency will purchase: two years after a Chapter 13 bankruptcy; four years after a Chapter 7 bankruptcy; and five years after a foreclosure.
Borrowers who have been foreclosed on, furthermore, must put 10 percent down, have a credit score of 680, and must wait an additional two years before they become eligible to purchase a second home or an investment property. Freddie Mac’s rules are the same.
But the agencies include provisions for "extenuating circumstances," which, if met, reduce the required waiting periods — to two years on a bankruptcy and three years on a foreclosure.
Extenuating circumstances are credible excuses for the bankruptcy or foreclosure that can be interpreted to mean that the likelihood of a recurrence is very low. The case is made in what lenders call a "cry letter," which is included in the borrower’s application.
The burden of proof is on the borrower. The agencies will be looking for a multiple-cause explanation for the bankruptcy or foreclosure. People lose their jobs; they get sick; they have accidents; they suffer deaths in the family; they are victimized by fraud; etc. Not one of these in itself is likely to be viewed as an extenuating circumstance, but a combination of them might.
The agencies will also look for evidence that, whatever the causes of the past problem, the current situation of the borrower is one that is reasonably secure against a recurrence. In addition, they want the borrower to document that since the occurrence of the bankruptcy or foreclosure, the borrower’s capacity to handle financial affairs has improved.
A rising credit score and an ability to make a significant down payment on a forthcoming loan are good evidence of this.
The major hurdle facing the borrower who wants to plead extenuating circumstances is convincing the lender. Some loan officers will help borrowers craft the letter, because they know what the underwriters are looking for, but the prospect of success is much lower than it was before the financial crisis.
Every aspect of loan underwriting has gotten tougher, and the ability to plead extenuating circumstances is no exception.
FHA’s rules on bankruptcy, foreclosure and extenuating circumstances are more liberal than those of Fannie and Freddie. For example, under FHA rules a borrower must wait only two years following discharge from a Chapter 7 bankruptcy, and they can qualify while they are still in a Chapter 13 bankruptcy. They need only to document that all payments within the bankruptcy plan have been made on time for a year, and that they have permission from the court to take a mortgage.
The challenge to borrowers who need an FHA mortgage is that most lenders have more restrictive rules than FHA. They don’t want to take the risk that high default rates on the FHA loans they originate will get them tossed out of the FHA program.
There are a few FHA lenders who are as liberal as FHA, but charge rates and points well above those posted by other lenders. They are the subprime lenders of the post-crisis market, and should be avoided if at all possible.