Over the weekend, I received a letter from a gentleman who found my Chapter 13 bankruptcy blog online and had a few more specific questions.  So i decided to post the questions and answers here (with his permission, of course) for everyone to see.

Here's a list of the questions (in bold):

"Hello John- Your chapter 13 and FHA loan article is very concise and helpful. A few additional questions- When opening at least 3 new credit lines should they be a combo of installment and revolving with low or high balances from month to month? "

I would recommend getting two revolving accounts and one installment account to even out the mix.  10% of your credit score is based on having a fair mix of credit, so two revolving and one installment account should do the trick.  As far as the balances, there's no need to keep a high balance on the credit cards.  In fact, this can hurt in the long run because a significant part of your credit score is determined by debt to limit ratios for each open account.  Ideally, i would recommend keeping the balance of the credit cards below 25-50% of their respective limits at all times.

"And... We are in a chapter 13 ( five year plan and currently on month 19) My wife has been on her salaried job for 19 years and I am just starting a new salaried job. Have been out of work for 9 months yet the new job is what I did before- Does FHA still require a full 2 years for me or less time to qualify?"

FHA does require a two year employment history.  However, an underwriter may grant an exception to this rule if the job loss was due to factors beyond your control and if the new job is comparable to the previous job. FHA will still want a full two year work history, so they will just require documentation of the previous two years before the nine month job loss.  Going from a salaried job to another salaried job is just fine.  If you would have started your own business this go-round, FHA would have required a two year history of earnings for the new business. 

If we wait for the Chapter 13 to run its full 60 month course can we apply for an FHA loan the day after? It seems odd that one can apply for a FHA loan while actually in a Chapter 13.

I agree it seems odd, but it's the truth.  FHA does allow a borrower to obtain an FHA loan even if they're currently in a Chapter 13 bankruptcy.  However, there are a few guidelines and requirements that must be met:

• The borrower must have made at least 12 months of timely payments in the Chapter 13 repayment plan. 
• Payment history on accounts not included in the bankruptcy must be near perfect.  This is ultimately an underwriter's call, but they are typically very strict with regards to payment history for all accounts once a bankruptcy has been filed.
• The borrower must meet all other underwriting requirements to obtain an FHA loan (acceptable job history, debt-to-income ratios, cash reserves, credit score, etc).  A loan officer and underwriter will make this determination. 
• The bankruptcy trustee must give written permission for the borrower to obtain a mortgage.  This is true for both purchases and refinances.  To the best of my knowledge and based on my past experiences, there are no specific guidelines for this, but the trustee will generally not approve a request to increase the current payment by very much if any at all.  For example, a person who pays $1000 per month for rent would likely be restricted from purchasing a home with a mortgage of over $1000 per month.  An exception could possibly be made in cases where a specific and compelling need to increase the size of the family home due to a chance in familial status is present (such as an elderly parent having to move in with the family or the birth of a new child).  If you have specific questions, please contact the bankruptcy trustee directly. 

Once the bankruptcy is completed (discharged) and all payments have been disbursed to creditors, you may apply for an FHA loan without having to obtain a letter of permission from the bankruptcy trustee.   But as I mentioned above, it may be possible to obtain a mortgage prior to discharge of a Chapter 13 bankruptcy.  This may or may not be a good idea, depending on your individual financial situation. 

It's very important to focus on rebuilding your financial strength both during and after a bankruptcy.  Ideally, a buyer should try to save at least twelve months of cash reserves in addition to the money needed for down payment. 

Also, make sure to keep all records pertaining to the bankruptcy, including the full petition, discharge and especially the record pf payments to the trustee.  It's not uncommon to see errors on accounts that have been included in a bankruptcy because the creditor did not note the account as included in a bankruptcy. 

Feel free to email me with any specific questions related to this or any other issue regarding credit, mortgages or real estate in the Dallas / Fort Worth area. 

Despite the various reasons why people may find themselves in a financial bind that damages their credit rating, the major obstacle that stops most from rebuilding their credit is lack of knowledge regarding how credit scoring works and what specific steps should be taken to ensure a quicker recovery. 

The popular myth is that once a person's credit score is damaged from late payments, collections, a bankruptcy or even a foreclosure, those issues must be resolved or removed from their credit report or they face a seven year curse of bad credit. 

It's almost like the old tale about breaking a mirror - once the damage is done, the only thing that can remove the curse is to wait around for the seven years of bad luck to pass.

This myth ends up becoming a self-fufilling prophecy because doing nothing instead of taking proactive steps to rebuild credit will often guarantee a prolonged period of bad credit.  And when it comes to qualifying for a mortgage loan, lenders are usually forgiving of past mistakes if a new track record of responsible credit history can be established after the fact.  And that is true even in today's new reality of tighter mortgage qualification guidelines. 

In many cases, a person who encounters a major setback such as a repossession or bankruptcy may be able to qualify for a mortgage in as little as two years.   In other cases of minor credit issues, such as sporatic late payments and/or collections, the wait time to qualify for a mortgage might even be less than a year, depending on the overall situation. 

In cases where a home loan applicant has experienced past credit issues, a mortgage lender will typically want to see THREE things before they will consider approving them for a loan:

1. An explanation and sometimes documentation of the reason for the bad credit and some type of assurance that this resulted from circumstances that are not likely to recur.  Some oversimplified examples of this would include a job loss, a divorce or ending of a relationship, an illness or injury, a death in the immediate family or some other type of event that most everyone experiences at some point in life that results in a financial hardship.  Even an admission of irresponsibility with regards to past finances may be acceptable, provided the applicant has since demonstrated the ability to manage their finances properly. 
2. A twelve month history of on-time payments on at least three accounts, preferrably accounts that report the payment history to the credit bureaus.  This usually also includes a satisfactory rental or mortgage payment history for the last 12 months. This is a MANDITORY MINIMUM REQUIREMENT to obtain most types of mortgages.  It is also the one thing that most consumers aren't aware of that keeps them from qualifying for a home loan for a much longer period of time after experiencing a financial setback that adversely affects their credit rating.  Many assume that since bad credit lingers on their report for seven years, it may take that long before they can qualify for a mortgage.  The secret is knowing how to obtain credit with a bad credit rating.
3. Proof that the applicant has sufficient resources to afford the monthly mortgage payment and that they will likely be able to pay on time each month.  Of course, this is something required of all home loan applicants regardless of past credit history.  This boils down to character, capacity and capital, known as the "three C's of underwriting".  Character can be summed up to a person's overall credit and payment history, capacity is their ability to repay (income and stability of employment) and capital is both the down payment (equity) and the amount of money they will have left over after closing.  Every loan has specific requirements for each of these, and a strength in one area may help to overcome a weakness in another, depending on the overall picture. 

So the real question is "How does a person with bad credit go about obtaining credit in the first place?" Well that's actually easier than most people think.  Secured loans and secured credit cards are a form of credit that can be obtained by virtually anyone, regardless of past credit history. 

What is secured credit?  It's basically any type of credit that is secured with collateral (in this case, CASH).  Most banks and nearly every credit union offers secured credit cards, but very few actually promote this service. 

A secured credit card usually requires a minimum security deposit of $300-$500 dollars, which is held as collateral for repayment of any balance incurred on the card.  The credit limit is usually equal to the amount of the deposit.  In other words, a fully functional, major credit card that reports to all three credit bureaus can be obtained by nearly anyone by simply putting up a cash deposit in a savings account with a bank or credit union that offers this service. 

And in addition to secured credit cards, many of these institutions offer secured installment loans as well. 

But why on earth would someone put up a $300 deposit to obtain a credit card with a limit of $300?  Doesn't it make more sense to just spend the cash and avoid credit entirely?  Well, normally it would.  But the purpose of obtaining a secured credit card isn't to actually borrow money, it's to reestablish a solid credit history. 

Unfortunately the credit bureaus can only generate a credit score based on data that's reported to them by creditors, not on other factors such as income, employment or a person's ability to save money.  And paying bills such as insurance, utilities and rent do not usually help one's credit score since these companies rarely report the payment history to the credit bureaus. 

So unless there's something to report, the bad credit from the past is the only thing the credit bureaus have to consider.  And that's where people get into a pickle with credit once they've had a setback and have closed all of their past accounts.  The secured credit card is the catalyst that helps to actually rebuild the credit score. 

Having said all of this about credit repair and restoration, I would not recommend someone buy a home that isn't financially ready for the challenge.  Owning a home isn't like renting, it requires a steady supply of time and money to own and maintain a home.  There is no maintenance man to call when the toilet overflows at 4AM or the air conditioner stops working in August.  

Rebuilding credit is very important, but rebuilding and reestablishing overall financial health, including building up a six to twelve month reserve of cash, should be top priority for anyone who has experienced a financial setback.

IF YOU HAVE HAD A PERSONAL FINANCIAL AND/OR CREDIT SETBACK AND WOULD LIKE MORE INFORMATION ON THE RIGHT STEPS TO TAKE TO REBUILD YOUR CREDIT, PLEASE CALL OR EMAIL ME TO SET UP A CONSULTATION.  I WORK WITH A NETWORK OF LENDERS THAT SPECIALIZE IN CONSULTING WITH CREDIT-CHALLENGED CLIENTS THAT NEED SOME FREE GUIDANCE ON WHAT STEPS TO TAKE TO QUALIFY FOR A HOME LOAN AS QUICKLY AS POSSIBLE. 

10% OF YOUR CREDIT SCORE IS DETERMINED BY NEW CREDIT AND CREDIT INQUIRIES. 

As far as new credit goes, the scoring model tends to deduct points when new accounts are established, but the number of new accounts is also factored.  In other words, opening one or two new accounts in a short time period may lower the score, but opening several will have a greater impact.  So your score may certainly drop if you open new accounts, regardless if they are mortgage, installment or revolving accounts, but as time goes by and a payment history is established on those accounts, the score will tend to increase.

And as far as inquiries are concerned, the effect they have on the score also varies by type of inquiry, as well as the number of recent inquiries.   Inquiries made by companies seeking to pre-screen consumers for unsolicited offers of credit (a.k.a. junk mail and telemarketing calls of credit offers) do not affect your credit score.  Neither does requesting your credit report yourself.  The only inquiries that deduct points are those that result from your direct application for credit.

However, inquiries made by mortgage and auto finance companies are treated differently than inquiries for credit cards and consumer finance accounts.  The credit bureaus realize that there is a difference between someone shopping for a mortgage and someone rapidly applying for credit cards.  Most consumers will want to "rate shop" while looking to purchase a big ticket item, such as a car or a home, so the scoring model counts all inquiries made in a 30 day period from a mortgage or auto finance company as just one inquiry.  In addition, it counts all inquiries made within a 14-45 day period prior to the most recent 30 days (depending on the version of the scoring model), as only one inquiry.  So the bottom line is that rate shopping for a home or a car won't "destroy" your credit.  But if you apply for an excessive number of credit cards in a short period of time, this may lower your score quite a bit.  The credit bureaus assume this is because you are in a desperate position to obtain credit, which means your risk of default may be much higher. 

Inquiries and new accounts should be kept to a minimum, but it's impossible to obtain credit without doing both.  The quantity and frequency is what has the most impact.  Keep it to a bare minimum and you shouldn't have a problem. 

Many people who have no credit or bad credit often apply multiple times for unsecured credit and are denied.  Although this is frustrating, it's just a reality of the situation.  Secured credit cards can be obtained by nearly anyone, regardless of credit history, so they're a great option for people with bad credit that need to reestablish and rebuild credit.  Applying for too many cards will only keep your score down and will prolong your credit issues. 

It may not seem fair that the credit bureaus penalize consumers for applying for and obtaining credit, but truly good credit is something that has to be earned over time.  They really don't penalize that much for new accounts and inquiries, as long as they are kept to a minimum over a short time period.  It goes without saying that too much credit can lead to financial problems, and a good credit history and credit score can only be achieved over time.

So just to recap:

35% of the score is determined by PAYMENT HISTORY

30% of the score is determined by ACCOUNT BALANCES

15% of the score is determined by LENGTH OF CREDIT HISTORY

10% of the score is determined by TYPES OF CREDIT USED

10% of the score is determined by NEW CREDIT and CREDIT INQUIRIES

Those five factors, as analyzed by the credit scoring model created by Fair Isaac and Company, determine ones FICO® Score.  The FICO® Score is the score preferred by most lenders.

I hope this series has been helpful.  Unfortunately, the credit scoring model looks at many factors and the credit bureaus only give us this set of five factors as a guide.  However, anyone who follows these guidelines and makes a conscious effort to live within their means and budget for life's rainy days will have a good chance of maintaining a good credit score.  Remember, good financial planning is more important than a good credit score, but is also essential to maintaining a good score.  Nowadays, creditors, insurance companies and even many employers use credit scores for evaluation of their employees and clients.  Managing your finances and credit properly has a profound impact on your life in more ways than you might think.

10% OF YOUR CREDIT SCORE IS DETERMINED BY THE TYPES OF CREDIT THAT YOU HAVE.  

Unfortunately, the credit bureaus are rather vague about exactly how many of each type is ideal, but it's safe to say that having too many revolving or too many installment accounts can cause the score to drop.  Installment accounts, such as car loans and mortgages, can have a positive effect on the credit score even after they are closed, whereas revolving accounts, such as credit cards and consumer finance accounts, usually stop impacting the score once the accounts are closed.  Also, the credit bureaus tend to value installment loans higher since creditors tend to require more documentation for these loans, such as proof of income, assets and a more in-depth analysis of debt-to-income ratios. 

Also, major credit cards, such as Mastercard, Visa, American Express and Discover, tend to have a higher score value than department store or other finance company cards.  Consumers who are looking to establish credit should consider getting a secured credit card that is issued by one of the four major credit card issuers instead of applying for a department store credit card.  Many department stores will not even grant an approval unless you have at least one major credit card. 

Having a fair mix of credit can help to optimize your score, but it should not be your only consideration.  If you read the first three parts of this series, then you already know that payment history and account balances make up the majority of the scoring factors.  So worry about those more, especially if you are just establishing or rebuilding your credit. 

So far we've covered four of the five factors that make up credit scores:

Payment History - 35%

Account Balances - 30%

Length of Credit History -15%

Types of Credit - 10%

These four factors make up a total of 90% of your credit score.  The final factor, new credit, makes up the last 10% of your score, which I discuss in detail in Part 5 of this series.

15% OF YOUR CREDIT SCORE  IS DETERMINED BY HOW LONG YOU'VE HAD CREDIT ESTABLISHED. 

This doesn't mean how long you've had an actual credit report on file with the bureaus.  The majority of people have had some kind of credit file since they were 18, so that would effectively amount to age discrimination if it were that simple.  This factor looks at two main sub-factors: The average age of your accounts and also the age of your oldest account on your credit report.

The age of the oldest open account is something that people often overlook as being an important part of their credit score, and is also something that people can easily sabotage without ever realizing they are doing harm to their score.  Often times, consumers run up rather large balances on accounts, such as credit cards, and may struggle for a long time to pay them off completely.  When this happens, people are often elated and will sometimes close the account (or multiple accounts) to keep themselves from ever charging it back up again. 

While this may be a good form of financial self-discipline, it's also a good way to drop your credit score by a substantial amount of points very quickly.  Instead of closing the account, try cutting up the actual credit card if you are worried you might be tempted to use it.  This will eliminate your ability to use the card most places, since the magnetic strip will be destroyed and other info, such as the expiration date and the three digit card security code. 

The other factor, the average age of accounts, is affected whenever new accounts are opened or old accounts are closed.  The effect of opening new accounts can be disheartening, but your credit score will eventually go back up within a few months as long as you keep the balances low and make all of your payments on time. 

The age of your accounts is important, and it's a good reason why people with bad credit or no credit should consider getting a secured credit card to establish a credit history.  The sooner you take the initiative to start rebuilding your credit, the sooner your credit score will get to a point where you can obtain competitive interest rates. 

The spread (difference) between rates for good credit borrowers and rates for those with less than perfect credit is increasing dramatically because of the fiancial crisis.  So the long term cost of having bad credit is increasing, despite the fact that interest rates are actually dropping.

So now we've covered three of the five factors that make up your credit score:

Payment history - 35%

Account Balances - 30%

Length of Credit History - 15%

These three factors make up 80% of your credit score.  Obviously they are the most important ones, but two other factors are also considered that have a smaller but yet important impact.  Now check out Part 4 of this series, which discusses the types of credit used.

ACCOUNT BALANCES MAKE UP 30% OF YOUR CREDIT SCORE. 

And as with payment history, there are many different facets to this factor.  For example. the total amount owed on all accounts is considered, but so are the individual account balances relative to their credit limits, or the "high balance" on each account.  This is particularly important on revolving accounts, such as credit cards.  The scoring model compares your account balances to the credit limits.  Whenever the balance exceeds 50% of the credit limit, this can lower the score, often by quite a bit.  You might be surprised how much your score would increase if you just paid down all of your credit cards to 50% or below their respective credit limits.

One misconception consumers often have is that paying off their credit cards every month means that their score will never drop because of high, or carried, credit card balances.  This is actually not true because most companies only report to the credit bureaus once a month, and it's often at a time when the balance is at its highest.  Every company reports at different times, and individual companies may report different accounts on different days of the month.  It's very confusing, and there's usually no way to know for sure without asking your card issuer.  And chances are if you call them, there's a good chance they won't even be able to tell you.

For example, let's assume you have a credit card with a $1000 balance.  Each month, you charge approximately $800 in expenses.  Even though you pay the full balance each month, the credit bureaus will probably show an $800 balance at any given time, depending on how fast you charge up the balance and also what day of the month they report to the credit bureaus.  So the smart thing to do would be to start using another credit card once the balance got close to $500.  Or you could ask the credit card issuer to raise your credit limit to $1700 so there would be little chance you would exceed that 50% threshold. 

Consumers looking to qualify for a mortgage in the near future should take the time to analyze their revolving accounts and try to pay down the ones with the smallest balances first to below 50% of their credit limits.  This is one of the easiest ways to optimize your credit score very quickly (assuming you have the extra cash to do that, of course). 

Credit card and revolving account balances seem to have the most profound impact on credit scores.  Other balances, such as mortgages and car loans are definitely considered as well, but the credit bureaus realize that having a high mortgage balance in and of itself doesn't necessarily make someone a higher credit risk.  But high balances on credit cards can definitely indicate a problem, especially if there are multiple accounts that are over 50% of their credit limits.  The closer you get to maxing them out, the lower your score will drop as well.  So take the steps to optimize your score and keep your balances low.  Credit cards should never be used to pay for things you can't afford because the compound interest will enslave you to debt for many years if you're not careful.  But credit cards provide many useful consumer benefits that can be very helpful and valuable if used in a responsible manner.

So far, we've covered two of the five factors of credit scoring:

Payment History - 35%

Account Balances - 30%

Just these two factors alone make up 65% of your credit score.  The last three make up just 35% of the score, but they are still very important.  Check out Part 3, which talks about the length of credit history.