Can you recover from a foreclosure or short sale? When it happens to you, it can feel like the end of the world. But it certainly doesn't have to be. As the Facebook meme puts it, "The happiest people don't have the best of everything; they just make the best of everything." If you make the best of the major setback that a foreclosure obviously is, you can move on. And you might become a homeowner again sooner than you'd think.
Your Goal to Recover from a Foreclosure
Nothing you can do is going to see you get approved for a mortgage overnight. But some people are able to qualify again just two years after their foreclosure. Whether you're likely to be among that fairly small and happy number is going to depend on three factors:
- How bad your financial situation was – The greater the number of bad loans and the bigger your arrears, the longer you're going to have to wait for your new mortgage
- How much better your situation is now – You want to show that the principal cause of your problems (sickness, unemployment, a drop in salary, divorce ... whatever) is well and truly behind you
- How well you've recently been managing your money – You need a sustained period before your application during which your credit report had no blemishes and your credit score improved significantly
Your foreclosure is going to remain a red flag on your credit report for seven years. The only way around that is to clearly demonstrate to lenders that you're once again (or have turned a new leaf and have become) a responsible borrower and good money manager with appropriate resources who's worthy of their trust. And that, in a sentence, is your goal.
Unless, that is, your foreclosure was very nearly seven years ago. Then you may be better off waiting for it to be erased from your credit report, at which point that red flag will be eliminated. Whether it makes more financial sense to wait in the hope of being offered lower mortgage rates (though some lenders ask on application forms whether you've ever had a foreclosure) or to go ahead and maybe pay a higher one now will largely depend on how quickly home prices are rising in the area in which you want to buy. You'll also want to keep an eye on where mortgage rates are heading.
Cut Your Debt
Lenders look hard at all mortgage borrowers' debt-to-income (DTI) ratios. You can calculate yours easily: Tot up all your debt payments each month (including those you'll make on your new mortgage) and divide them by your gross monthly income. Mentally move the decimal point two places to the right, and the figure on your calculator is the percentage of your income taken up servicing your debts. Learn more at "Calculating your debt-to-income ratio."
For most borrowers, lenders are happy if that ratio comes in at 43 percent or less. But, with that foreclosure in your rear-view mirror, you're not most borrowers. And to show lenders that you are indeed a responsible borrower and good money manager, you should aim to take your DTI ratio as far below 43 percent as you can get it.
Manage Your Credit
Now for a contradiction. Having just told you to cut your debt, it's time to tell you not to eliminate it completely. You can't prove you're a responsible borrower if you're not borrowing. So you need some on-time payments on your credit report, and your credit score can't get the boost it needs without them.
Ideally, you want at least one credit card and one personal loan while you're trying to recover from a foreclosure, because credit scores thrive on a mix of revolving (plastic) and nonrevolving (loan with a set term and an unchanging monthly payments) credit. But how can you get those when your report and score are shot? You're probably going to have to start off with a secured credit card and a personal loan secured by a certificate of deposit. In some ways, these are crazy, because you can only borrow as much as you deposit, meaning you're effectively paying interest to borrow your own money. But they can be a quick way to repair your credit, and with luck you'll be offered a proper, unsecured credit card once you've proved yourself. Two warnings:
- Don't expect to qualify even for these secured products while your finances are still in a serious mess
- Make sure the card and loan you select report your borrowing and payments to all three major credit bureaus
Obviously, you shouldn't apply for any new credit, even secured borrowing, before you're absolutely sure you can make on-time payments every month. And you shouldn't regard them as sources of credit. With plastic, something called your "credit utilization ratio" is vital. It's the proportion of your available credit (your credit limit) to what you use (your balance), and it needs to be low. For most borrowers, anything over 30 percent on any one card or across all cards is harming their scores. But we've already established you're not "most borrowers," and you should aim to clear your card balance and keep current with your loan every month.
Focus on Your Credit Score
Your credit score is based solely on information gleaned from your credit report, so if you get your score right, your report should be fine. Of course, you shouldn't ignore your report. You have a statutory right to a free copy from each of the three big credit bureaus each year, and you should take advantage of that at annualcreditreport.com.
But it's easier to constantly monitor your score, especially if you use a service that provides monthly updates and summaries each month. Conveniently, LendingTree offers precisely that service entirely free of charge. You won't even have to provide your credit card details.
FICO, the company whose scoring technologies are used in most lending decisions in America, reveals how your score is determined:
- Payment history – accounts for 35 percent of your score, which makes late or skipped payments very bad news
- Amounts owed – 30 percent, so your credit utilization ratio on your plastic is vital
- Length of credit history – 15 percent, not much you can do about that, except to not close existing accounts unnecessarily
- Credit mix – 10 percent, which is why a mix of credit cards and personal loans helps
- New credit – 10 percent, every time you apply to open a new account, your score takes a small and temporary hit (though shopping around for a mortgage among numerous lenders results in just one of those hits, providing you do so within a couple of weeks)
Discover more about repairing your credit from a low point at Tips for Building a Credit Score from Nothing.
How long it will take you to recover from a foreclosure depends on many variables, and there's no way any general article can make a worthwhile prediction. What is certain is that the sooner you start to get your finances in order and your credit score up, the sooner lenders will take you seriously. And that's the quickest way to make the best of the setback you suffered.