If you fail to pay a bill, loan or debt, the creditor -- the company you owe money to -- may sell or turn over the account to a collection agency to try to recover the debt. The account is then listed as a collection account on your credit report.
Collection accounts remain on your credit report for seven years and can negatively impact your credit score. The potential decrease in your credit score caused by a collection account depends on your score prior to the issue, the amount of the debt, when the account when into collections and the status of the account.
For example, if you pay off the outstanding account balance, it is listed as a paid collection on your credit report, and the impact to your credit score is lower. Additionally, the more time that has passed since the account went into collections or you paid the balance in full, the more likely your credit score is to recovery following the initial drop.
On the other hand, if the collection account is open, the negative effect on your credit score may be greater, even if you are making payments on the account. The more recent the account went into collections and the larger the outstanding debt balance, the more you should expect your score to decrease. For example, a $2,000 loan that went into collections last month typically causes your score to drop more than a $100 debt that went into collections three years ago.
So how does a collection account affect your ability to qualify for a mortgage?
A collection account impacts your ability to get approved for a mortgage in several ways. First, as outlined above, having an account in collections can cause your credit score to go down. In general, the lower your credit score, the higher your mortgage rate and monthly payment. A higher rate makes it more challenging to qualify for a mortgage or may reduce the loan amount you can afford. Additionally, if your credit score is too low, you may not be able to qualify for the loan or you may be ineligible for certain mortgage programs.
This is why we recommend that you check your credit report several months in advance of applying for a mortgage. Checking your own report does not hurt your score and enables you to identify negative issues such as collection accounts.
If your score is too low, you may decide to wait before you apply for the mortgage. Or you could reach out to the collection agency to resolve the issue. Although the account remains on your credit report, proactively addressing the issue may boost your credit score and better position you to get approved for a mortgage.
In an ideal scenario, you pay off the account in full before you apply for the mortgage, although we should emphasize that you usually are not required to pay off collection accounts to qualify for a mortgage (more on that below).
The second best approach is to establish a payment plan with the debt collection agency. Depending on the payment amount and the type of the account, the lender may include the payment in your debt-to-income ratio, which reduces the mortgage amount you can afford, but this is approach is better than not addressing the account at all.
If you do pay off your account or set up a payment plan it is important to keep copies of any payments or account statements. If your credit report is not up-to-date, you can provide these documents to the lender when you apply for the mortgage.
Having a plan in place that addresses credit issues is always a good idea and the positive news is that a collection account usually does not prevent you from qualifying for a mortgage. Approval guidelines for collection accounts vary by loan program. Below we outline how a collection account impacts your ability to qualify for conventional, jumbo, FHA, VA and USDA mortgages.
Conventional Mortgage - Single-Unit Primary Residence. If you are buying a single unit property, you are not required to pay off or establish a payment plan for the collection account, unless required by the lender. In most cases, the collection account does not affect your ability to qualify for the mortgage.
Conventional Mortgage - Two-to-Four Unit Primary Residence or Second Home. Collection accounts totaling more than $5,000 must be paid off in full before your mortgage closes.
Conventional Mortgage - Rental Property. Any individual collection account with a balance of at least $250 and accounts with a combined balance greater than $1,000 must be paid off in full before your loan closes.
Jumbo Mortgage. Qualification guidelines for jumbo mortgages vary by lender and are less standardized. Some lenders may not require you to address the collection account, some lenders may require you to provide a letter of explanation that explains the issue and other lenders may require you to pay off the account or establish a payment plan prior to closing, depending on the amount, creditor and date the account went into collections. If you are applying for a jumbo mortgage we recommend that you check with the lender in advance to understand its collection account policy.
VA Home Loan. VA Program guidelines regarding collection accounts vary depending on the number of accounts and other factors. Applicants with one or two collection accounts and otherwise good credit and payment histories usually are not required to pay the accounts to qualify for the mortgage, although this is the preferred approach.
Applicants with more challenging credit profiles and a history of multiple collection accounts may be required to establish payment plans for the accounts and show an on-time payment history of at least twelve months to qualify for the mortgage.
Because VA qualification guidelines are more subjective, we recommend that you contact multiple VA lenders to determine your eligibility.
FHA Mortgage - Standard Underwriting. If the total balance of your collection accounts is $2,000 or more, you are required to either pay off the account balance in full or establish a payment plan. Please note that for an FHA mortgage, medical account collections are excluded from your total account balance.
If you establish a payment plan, the monthly payment is included as debt in your debt-to-income ratio, which may reduce the loan amount you qualify for. If you cannot agree to a repayment plan with the creditor, the lender includes a monthly debt payment equal to 5% of the collection account balance in your debt-to-income ratio. For example, if your outstanding collection account balance is $2,000, the lender adds $100 to your debt-to-income ratio ($2,000 * 5% = $100).
FHA Mortgage - Manual Underwriting. If your loan application requires an exception to an FHA qualification requirement, such as a lower than permitted credit score or higher than allowed debt-to-income ratio, your lender submits your application using manual underwriting. The manual underwriting process involves a more comprehensive review of your application.
If you have a collection account and your lender manually underwrites your application, the lender is required to provide documentation that explains the reason why your application should be approved. The lender is also required to review the circumstances that caused the account to go into collections.
You are required to provide a letter of explanation that addresses each collection account including why the issue occurred and the steps you took to resolve the issue. Depending on the documentation provided by your lender and you, and the circumstances that caused the issue, your application may be approved or rejected.
USDA Home Loan - Standard Underwriting. The collection account guidelines for a USDA home loan are basically the same as for an FHA mortgage. If your collection account balance, excluding medical collections, is more than $2,000, you are required to pay off the accounts in full or set-up a payment plan with the creditor, in which case the monthly payment is included in your debt-to-income ratio. If you cannot establish a repayment plan, the lender includes a payment equal to 5% of your total account balance in your debt-to-income ratio.
USDA Home Loan - Manual Underwriting. If your lender manually underwrites your loan, the lender is required to submit a letter that explains the collection account and why your application should be approved. You are also required to provide a letter of explanation for each collection account as well as any supporting documents that demonstrate how you addressed the issue.
Please note that manually underwriting a mortgage application requires more time, effort and documentation from both the lender and the applicant. Not all lenders work with applicants that require manual underwriting so you may need to contact multiple lenders to find one that does.
Additionally, the requirements outlined above are for specific loan programs and lenders may apply their own, more challenging qualification guidelines. In some cases a lender may require you to pay off a collection account as a condition to qualify for a mortgage even if it is not required by the loan program.
In closing, for most applicants, a collection account does not prevent you from getting approved for a mortgage but you need to find the right lender and program.
Conventional Mortgage Collection Account Guidelines: https://www.fanniemae.com/content/guide/sel040318.pdf
VA Mortgage Collection Account Guidelines: https://www.hud.gov/sites/documents/40001HSGH.PDF
FHA Mortgage Collection Account Guidelines: https://www.benefits.va.gov/WARMS/docs/admin26/pamphlet/pam26_7/ch04.pdf
USDA Home Loan Collection Account Guidelines: https://www.rd.usda.gov/files/3555-1chapter10.pdf