MORTGAGE LENDING UPDATE

By David Griffin, Past President of 
Mortgage Bankers Association of Middle Georgia

Conventional guidance on bankruptcies

The borrower's credit history is a primary deciding factor in a mortgage application because it is one of the most important indicators of how a mortgage will perform. The presence of a prior bankruptcy or foreclosure in a borrower's credit history is evidence of significant derogatory credit, thus it increases the likelihood of a future mortgage default. A borrower whose credit history includes a prior bankruptcy filing or foreclosure is more likely to default on the mortgage obligation than a borrower whose credit history does not include a bankruptcy or foreclosure, even if the borrowers have similar credit scores. The more recent the bankruptcy or foreclosure, the higher the risk of default. Therefore, a lender should consider the presence of a prior bankruptcy or foreclosure as an added risk element that can represent a significantly higher level of default risk.  

The following information is provided by Fannie Mae (Federal National Mortgage Association or FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation or FHLMC) as guidance to lenders in underwriting conventional mortgage loan applications for applicants with prior bankruptcies.  

When assigning a risk assessment to the "prior bankruptcy or foreclosure", the lender should use the following as general guidance on the nature and significance of the default risk associated with the time that has passed since a borrower's prior bankruptcy was discharged or a prior foreclosure was completed (regardless of the type of bankruptcy or foreclosure-related action).

Generally, a prior bankruptcy or foreclosure that was discharged or completed within the past seven years will, at the very least, increase the risk of a mortgage default. If the bankruptcy or foreclosure was discharged or completed between three and four years before the date the mortgage is being underwritten, the lender should consider the bankruptcy or foreclosure as representing an increased risk. However, the lender may consider a bankruptcy or foreclosure that was completed or discharged four or more years before the date the mortgage is being underwritten as representing a marginal increase to the risk of default.

 A significantly increased risk assessment generally should be used when the borrower had a prior bankruptcy or foreclosure that was discharged or completed within the past three years.   The lender should keep in mind that we (FNMA/FHLMC) have specific eligibility criteria for reestablishing credit that must be satisfied before approving a new mortgage to a borrower who had a prior bankruptcy or foreclosure in his or her credit history. Generally, we require a minimum elapsed time of four years between the discharge of a bankruptcy or the completion of a foreclosure and the date of the mortgage application. However, when a bankruptcy is filed under Chapter 13 (or under Chapter 7, if the bankruptcy was the result of documented extenuating circumstances), we require only a two-year elapsed time for reestablishing credit.   When a borrower's previous credit history included a bankruptcy or foreclosure-related action, all of the accounts in the borrower's credit report must be current as of the date of the mortgage application. 

In addition, the borrower's credit record under the re-established credit history must include a minimum of four credit references, one of which should be housing related, such as a prompt record of payment of rent.   Three of the four credit references (including any rental housing reference) must have been active in the 24 months preceding the date of the mortgage application.   Obviously, the anticipation would be that there would be no new instances of late payments.   

(It goes without saying that significant late payments subsequent to a major financial crisis such as bankruptcy can be the kiss of death to a mortgage loan application.)   Next week I’ll share information about how bankruptcies are viewed in the Veterans Administration (VA) and Federal Housing Administration (FHA) guidelines.