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(Updated January 2015)
Foreclosure can be a dark cloud hanging over your credit score for years, especially if you want to purchase a home. However, if you have a poor credit score because of foreclosure, you don't have to be stuck with a bad credit mortgage with an unreasonably high interest rate.
During the first two years after foreclosure, your options will be limited when shopping for a new mortgage, as lenders generally won't approve a loan. However, this gives you the time to go into action.
How long must you wait?
The standard rule is that you can't get a mortgage backed by Fannie Mae or Freddie Mac for seven years after a foreclosure. For an FHA loan, it's three years while the VA's waiting period is only two years for qualified veterans and others with certain military affiliations.
However, those aren't hard-and-fast limits. You can qualify for a mortgage in less time than that if you can show your foreclosure was due to extenuating circumstances you had little or no control over. These may include a job loss, a serious illness or injury, the death of a income provider or a divorce.
These must be a one-time event that is unlikely to recur. If you can show that, you can qualify for a new mortgage backed by Fannie Mae or Freddie Mac as soon as three years after foreclosure, and for an FHA mortgage in as little as one year.
If you go through a private money lender (one who doesn't sell its mortgages to investors via Fannie Mae, Freddie Mac or the FHA), there may not be any waiting period at all. Their primary concern will be your income, down payment and the value of the property. Of course, you'll need to pay a hefty interest rate for such a loan, and the required down payment may be 30-40 percent of the home value or more - and if you had that kind of money lying around, you probably wouldn't have been foreclosed on in the first place.
The impact of foreclosure on your credit
Even with extenuating circumstances, you may still have trouble obtaining a mortgage 1-3 years after a foreclosure. That's because a foreclosure will put a serious hit on your credit rating.
According to the Fair Isaac Co., developers of the FICO credit scoring system, a foreclosure will reduce your credit score by 85-160 points, with the biggest hit on people who previously had higher scores. People who go through foreclosure also tend to have other hits on their credit as well, from unpaid bills - a credit card account that goes 30-90 days late can reduce your score anywhere from 40-135 points.
Foreclosures and late payments stay on your credit report for seven years. However, their impact on your credit score begins to diminish after only two years. So if you're paying your bills on time and keeping tabs on your credit reports and score, you may be able to qualify for a new mortgage once your FICO credit score rises into the low 600s.
FHA loans are easier to qualify for with a low credit score than Fannie Mae or Freddie Mac loans are - some lenders will now approve FHA loans with scores as lows as 620 or even lower. However, simply qualifying for a mortgage is not the same as being able to get an affordable one - poor credit mortgages tend to have high interest rates and fees, and may require larger down payments as well. So you might find that it makes better financial sense to wait for your score to recover a bit more before applying for a mortgage loan.
Steps for damage repair
There are things you can do to reverse a bad credit rating. Pay your bills on time and negotiate a lower rate of interest on your credit cards. Ultimately, lenders want to see a dependable track record.
Purchasing a new home means saving for a down payment all over again. And mortgage interest rates following a foreclosure may be outrageously inflated, up to three or four percentage points above current rates. However, if you can put 20 percent down, you can improve the terms of a mortgage and avoid PMI (private mortgage insurance). Unfortunately, if you have a credit score of 600 or less, you'll generally have no choice but to put down between five and 20 percent, anyway.
The key to lowering your mortgage interest rate, therefore, is to increase your savings rate. In order to do this, patience is key. Draft a budget that includes stashing a hefty amount of your monthly income into a savings account. Then, stick to the program.
Since mortgage lenders review the last seven years of your credit history, it's a good idea to document in writing why you have a foreclosure on your credit report. Track your credit, and keep trying to improve it.
Be a smart shopper
Ultimately, savvy shopping is the key to a new loan. Compare prices online to get the best deal.
Keep your spending in check, and you can secure a bad credit loan despite the foreclosure in your credit history. Once you do, the clouds will disappear, allowing the sun to shine brightly on your home.