February 22, 2021
Is It A Good Thing Or A Bad Thing To Pay-Off Collections Before Applying For A Mortgage
You decided to buy a house. Congratulations. Now comes the hard part: Qualifying for a mortgage. If you are like an average American citizen, your credit history is less than perfect. You decided to pull your credit report and saw that you have several accounts at collections. And as any reasonable person thinks, you said “If I pay them off, my credit rating will increase”.
The logic behind this thought is sound. But unfortunately, the credit reporting process deviates a little from causality logic. There are other things to consider before you take it upon yourself to start paying off old debt.
Before handling collections during the mortgage process, it is in your best interest to contact your mortgage broker. They deal with this situation day in and day out and they can tell you what is in your best interest. It could be paying off the debt or at least making payment arrangements, or you may be better off by letting the sleeping dogs sleep in peace.
Credit rating or credit scores, as they are most commonly known, gets calculated depending on many factors. The two most important factors in this calculation are:
- How much of your credit are you using
- Are you making all your payments on a timely basis
This goes without saying but to maintain a good credit score, you need to be making payments towards your debt on time, every time. This makes about 30% of your credit score. You miss a payment one time for one credit card. All your credit ratings will suffer. If you are having trouble making a payment to one or more of your creditors, do not play the emu and bury your head in the sand. Call them and talk to them. Make payment arrangements. If you are late 30 days or more and you have not attempted to contact the creditor, they will slap that late payment onto your credit report, faster than the blink of an eye.
Credit utilization is another sore point for the calculations. If you are using more than 30% of all your available credit, your credit score will suffer and this credit utilization is another 30% of your credit score. “What does 30% of available credit mean” you might ask, Well, let’s assume you have three credit cards and the total of your credit limit of all three cards is $10,000. You should not owe any more than $3,000 to the creditors, at any given time. If you are under 30%, you are good. If your utilization inches up, there goes your credit score down, proportionately.
Coming back to the debts and collections, all debts are not created equal. Debts older than 12 months may hurt you but not as much as freshly acquired debts. Creditors would love to sue you and collect the money owed to them but at the same time, they are business people. Unless the debt is large enough to spend time and money in courts, they tend to send you letter after letter and call you incessantly. But there are rules and laws about how far they can go in their collection efforts and for how long a debt is collectible. The length of the debt collection window varies by state and it is mostly somewhere between three to six years.
The creditor can keep the debt alive as long as it is not paid and keep it on your credit report, but after the sixth or seventh year, the effect of this debt becomes negligibly small. But how about the honor and the peace of mind? Right? Well, if it was your debt, it is always a good thing to pay it off, but sometimes everybody has bad things happen to them and fall into hard times.
One thing to keep in mind is if you acknowledge this debt is yours, verbally or in a written form, or by agreeing to pay it at a later date, you will reset the dormancy time all over and your old debt becomes a new debt and hurts your credit rating. Don’t do that. Even if you are planning to pay it off, do not tell the collectors.
The same thing can be said for the collections. For a debt to go into collections, it takes about 12 months from the date of the last activity on this account. So, your old debt had just entered the dormant period or about to enter it. If you make payment arrangements or even pay it off fully, it all of a sudden becomes a new debt. Even if it is paid off in full, it gets treated as a new loan and may hurt your credit in the short term, i.e., while you are trying to get a better interest rate on your mortgage.
And there is the FHA angle. A lot of people are unable to qualify for conventional mortgages right off the bat. So, they go the FHA route for a lower down payment and better rates. These loans are generally backed by Fannie Mae, The Federal National Mortgage Association. Fannie Mae is a publicly-traded company since 1968 and has investments everywhere. If your debt is going to hurt Fannie Mae, should you default on it, they might ask you to make arrangements before they underwrite your mortgage. If you owe a large sum of money to a major credit card issuer after they cancel your credit card, you are more than likely to face this scenario, as Fannie Mae has investments in many prominent financial institutions.
Again, dealing with old collections during the mortgage process is daunting work. One small thing you miss may cost you thousands of extra dollars throughout the life of your loan. Before you attempt anything on your own, talk to a mortgage broker and listen to what they say. This is their job to advise you on the best course of action, whatever that may be.
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