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Should You Pay Off Collections Before Applying for a Mortgage?

collection-accountYou want to put your best foot forward when you apply for a mortgage. That is why experts recommend checking your credit report first and clearing up any errors or problems. But what should you do if your credit report shows a collection account? Should you pay it to increase your credit score? Or leave it alone? It depends on the type and age of collection.

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Should you pay a collection account? It depends

There are several things that factor into the decision to pay a collection account. Before contacting a collector, get some answers:

How old is the debt?

Every state has a statute of limitation for debt collection. If your debt is more than four years old, it's uncollectable in many states.

In addition, older debts affect your credit score much less. You may be better off letting an old collection fade away if you can't pay it in full.

Resurrecting a collection account with a payment or settlement freshens it on your credit report and can harm your FICO score. Note that completely repaying an old debt won't harm your FICO score.

See the statutes of limitation for every state

Is it a new past-due account?

Past-due accounts go to collection when you stop making payments. For instance, if you charge up a credit card and then default on the account. Your creditor will send letters and probably call you. If it can't get you to pay up, the card issuer either hires a collection agency and pays it a percentage of whatever it collects from you, or it sells your account and the right to collect your debt to an agency.

Non-medical collections can also incur interest and collection costs and fees. Your credit card interest rate may skyrocket for missing a payment, and then the card issuer or collection agency gets to apply that rate to your unpaid balance.

Past-due accounts can do more damage because your credit history may take several hits. First, there are the missing payments to the original creditor. Then there is the collection itself, which can be reported immediately. And finally, if the agency sues you for payment, you'll have a judgment - a public record.

Has the debt been reported to credit bureaus?

If not, you may be able to prevent it from harming your credit score by negotiating a full, scheduled or partial payment right away. Get this arrangement in writing.

Is the creditor or collection agency willing to delete the collection from your credit history?

The newest credit scoring model, FICO 9, does not incorporate paid collections into your credit score. But most creditors still use older versions. For those older versions, a paid collection still hurts your FICO score. Paying the account only restores your credit rating if the bill collector agrees to remove the collection from your credit history altogether. This is called "pay for delete" in the credit industry.

How much do you owe?

Collection agencies have no problem taking people to court if the amount owed is large enough. If you owe a large amount or have several smaller accounts with the same collection agency, expect a lawsuit. You could end up owing court costs, interest and the original balance. And you'll still have the original collection on your credit report, plus a judgment. Serious stuff.

Is the collection a medical account?

By law, the collection agency must notify you when it receives a medical account. You have 180 days from that notification to pay the balance before they can report it.

Even better, once you pay the collection, the credit bureaus have to remove it from your credit report within 45 days. If you're about to apply for a mortgage and you have a medical account in collections or heading to collections, it might be smart to clear it from your credit report. Paying medical collections that are on your report does improve your credit score, especially if they are recent.

What about your honor?

Most of us feel better when we keep our promises. Paying a collection may help you sleep better at night. In addition, mortgage underwriters do see that you paid the account even if paying did not raise your credit score.

Related: Differences Between FICO 9 and Vantage Credit Scores

How to negotiate medical collections

Medical collections go away as soon as you pay them. But what if you need a payment plan or wish to negotiate a lower payoff? You might be able to negotiate a deletion or keep a collection from appearing after 180 days by agreeing to regular payments or a lump sum settlement. Medical collections accrue no interest, so a payment plan might work well for you.

Conduct your negotiations in writing and don't send money until you have a signed agreement in hand. If the collection agency insists on reporting your collection to credit bureaus, at least it will come off once the account is paid.

Check out this sample pay for delete letter

How to negotiate new collections and past-due accounts

Before sending any money to a bill collector, get a written agreement. You need to know if you'll be settling the account for less than the total balance or paying in full. Will you make a single payment or a series of payments? When are they due? Will you pay interest and/or collection fees? Most importantly, what happens after you make the agreed-upon payment(s)? Will the collection be deleted altogether from your credit history? Will it be reported as paid in full or reported as only partially-repaid?

When requesting something in exchange for payment, send a letter explaining what you are willing to do, and what you'd like in return. You can use this one from MoneyRates as an example. Only when you reach a written and signed agreement should you send in the promised money.

Check your credit after paying

If your collector agrees to a pay-for-delete arrangement, the paid account won't appear on your credit report or FICO score. That is the most desirable outcome. If the account remains on your report, once it's marked "paid in full," the FICO 9 scoring model does not include the collection in your credit score. Other scoring models will still count it.

FICO says that paying a collection in full will never harm your credit score. Only settling for less than you owe or entering into a payment plan restarts the clock on the debt. If you need to settle or pay your collection in installments, you may still be able to negotiate a pay for delete. Get this in writing and signed before sending any money.

Once you have paid according to the terms of your written agreement, check your credit reports from all three bureaus. Verify that the account is marked or deleted the way you expected. You can get your credit reports for free at www.annualcreditreport.com, the only site administered by the federal government.

Finally, remember that collection agencies can sue you for repayment. But they cannot show up at your workplace, harass you with threats or abusive language, arrest you, pursue you for debt you don't owe or call you before 8 am or after 9 pm.

Related: Your Credit Rights

Old collection accounts

If you have a collection account that's a few years old, you'll want to dig a little deeper.

Verify your state's statute of limitations

Every state has statutes of limitations on debt collection - typically three-to-six years. Bill collectors cannot sue to collect debts if they're too old. However, the debt is still yours and will not drop off your credit report just because the statute has kicked in. And be careful - you could accidentally restart the statute, making the debt collectible again, if you acknowledge that you owe the money, make a partial payment, or even promise to pay any part of it.

Delete erroneous or outdated information

If you don't actually owe the account, ask the credit reporting agencies (CRAs) to delete it. Or ask your mortgage lender to have a rapid re-scoring company clean up your report.

Don't reactivate the account

Collections are serious delinquencies and damage your FICO score heavily. However, the harm diminishes over time. Settling an old collection or starting a payment plan makes it appear new again to credit bureaus, and you can actually drop your score.

How should you deal with an old collection? First, do not talk to any bill collector who contacts you about an old debt. You don't want to accidentally restart that clock. Request (only in writing) documentation proving that you owe the debt and indicating that the collector is authorized to collect it. State plainly that you do no acknowledge the debt as yours. If they can't prove you owe it, dispute it with the credit bureaus.

If a collector tries to report an old debt to credit bureaus as though it were new, that's a violation of the Fair Credit Reporting Act, and you can have it removed. You can also make the creditor stop contacting you about a debt with a written request.

Related: How Private Is Your Mortgage Information?

Do you have to pay collections to get a mortgage?

That depends. If you can show that a debt is uncollectible due to the statute of limitations, you probably won't have to pay it. But if you do owe the money and it's collectible, you should pay it or establish a payment plan before applying for a loan.

Why do you want a payment plan for large collections? To make mortgage qualification easier. If you have a large debt, many mortgage lenders add five percent of the outstanding balance to your debt payments, reducing the amount that you qualify to borrow. For a $10,000 balance, you'd be hit with a $500 a month payment. If you can negotiate $250 with your creditor, you'll qualify more easily for your mortgage.

You might be even better off paying the collection with a personal loan, wiping it out and potentially lowering your payment as well. You'd pay $203 a month at 8% to zero a $10,000 balance in five years.

Your lender may require you to pay off a recent collection account. Fannie Mae, for example, says, "Delinquent credit…that [has] the potential to affect Fannie Mae's lien position or diminish the borrower's equity must be paid off at or prior to closing." That generally means judgments and tax liens, or anything that could result in a lien against your property.

This is why you may want to pay off a new, valid collection before applying for a home loan. However, you should negotiate the reporting of that debt when you discuss repayment terms.

Collections can require a variety of responses -- you may be legally obligated to repay them, morally obligated to repay them, or have no obligation at all. If you're not sure, a good mortgage lender can help you sort them out.

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