Paying off collections accounts is an action that many people undertake upon deciding that it is time to get ready for a mortgage. The challenge is.....paying off collections can lower your credit score. One of the most obvious financial steps people make is actually a trap that can turn mortgage approval to mortgage turn down.
There is a flaw in the scoring system that penalizes consumers who pay off old collections. This is what happens. The scoring system will lower someone's credit score dramatically upon a collection account being placed on the credit. Let's say that John has an unpaid utility bill for $200 at Vectren. Vectren grows frustrated and due to no response from two letters/statements, sends the account to Atlas collections. Atlas will immediately place the account onto the three credit bureaus. John's credit score is lowered by say "65" points for the collection. Collections are one of the worst items to hit a credit report only slightly better than a repo or forclosure.
As this collection ages (let's say it was placed on John's credit in 2007) it has less impact on the score. Maybe -40 by 2009, -25 by 2010, -15 by 2011. So here we are in 2011 and John wants to get a mortgage. The credit report shows an unpaid collection from 2007 to Atlas collection. The mortgage company wants it paid off. What John may not know is that the negative to his score might be down to -15 points.
If he pays the account off, here's what happens to his score. For collection accounts, the date that matters is the "last activity date". Currently his is 2007. If he pays the account, the "last activity date" is changed to the day he pays it off. In this case 2011. The scoring system then calculates the hit to the score based on a new activity date of 2011. This will cause his score to be (-65) for this "paid 2011 collection" rather then (-15) for an "unpaid 2007. Just a flaw in the system but reality.
The bottom line is.....if you are getting a mortgage do not pay collections before the closing. Have the loan officer make the collection payments an "at close" condition so that it is paid with the other closing costs and down payment. This step will eliminate the risk of your credit score dropping during underwriting and being turned down.