Collections on your credit report: what they mean for a mortgage

Fannie Mae: one-unit homes

Fannie Mae's Selling Guide separates accounts that are past due from those already in collection. Past-due accounts must be brought current. For collections, the rule for a one-unit principal residence is generous: borrowers are not required to pay off outstanding collections or non-mortgage charge-offs, regardless of the amount. Medical collections are excluded from the limits and do not have to be paid.

Stricter rules apply to two- to four-unit homes and second homes, where collections and charge-offs totaling more than $5,000 must be paid off at or before closing. If a lender marks an account to be paid at closing, the automated findings will say it must be paid.

Not having to pay a collection does not make it invisible. It can still affect your credit score and the lender's overall view of your file.

FHA: the $2,000 line

HUD's Handbook 4000.1 sets a dollar threshold. If the credit reports show cumulative collection balances of $2,000 or more, the lender must do one of three things:

• verify the debt is paid in full at or before closing, using acceptable funds;
• verify you have a payment arrangement and include that payment in your debt-to-income ratio; or
• if no arrangement is available, count 5 percent of each collection's balance as a monthly payment.

If the lender uses the 5 percent method, no extra documentation is needed. In community property states, collections of a non-borrowing spouse can count toward the $2,000 total unless state law excludes them.

Disputed accounts

Disputes can help when a collection is wrong, but they also draw attention. Fannie Mae's automated system first evaluates the loan with disputed accounts included. If it cannot approve that way, the lender must investigate the disputed accounts. Under FHA rules, $1,000 or more in disputed derogatory accounts is one of the triggers for manual underwriting. Dispute errors, but do it early, and keep the paperwork.

Deciding what to do

Confirm the debt. Check that it is yours and the amount is right. Collections are sometimes duplicated or reported after payment.

Ask the lender first. Paying an old collection does not always raise a score, and under Fannie Mae rules it may not be required. Under FHA rules, it may lower the counted payment.

Get terms in writing. If you settle or set up a plan, get a letter stating the amount and the terms before you pay.

Use your own money. Funds used to pay debts at closing must come from acceptable sources, just like the down payment.

Before you pay or settle

Talk to your loan officer before you pay a collection during the mortgage process. Paying can sometimes help, for example by bringing an FHA borrower's total below a threshold, but your lender should confirm how the payment will be treated. If you agree to settle for less than the full balance, get the terms in writing from the collector before you pay, and keep proof of payment. Make sure any payment comes from funds you can document, so the payment itself does not create a new question about large withdrawals or unexplained money.

The bottom line

Collections do not automatically block a mortgage. Fannie Mae does not require payoff on a one-unit principal residence. FHA requires payment, an arrangement or a 5 percent counted payment once balances reach $2,000. Check your reports, fix errors, and decide account by account with your lender.