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How foreclosures, short sales, other mortgage defaults affect credit

It's bad, but if you've kept up payments, you'll limit the damage, recover faster

By Linda Childers

If you find yourself struggling to make mortgage payments, your credit rating may be far down your list of concerns. However, experts say homeowners who act quickly and avoid delinquent debt tend to fare better and rebuild their credit scores quicker. 

With the weak economy, many hard-hit homeowners are trapped in too-costly mortgages and face the prospect of foreclosure, conducting a short sale, modifying their original home loan or even walking away from their home.

However, not all of them affect credit scores the same way. The impact on scores depends on how long the borrower was delinquent, how great a loss the lender took, state laws and other factors.

Looking to minimize the credit damage from getting behind in a mortgage, and recover your score as quickly as possible? Experts say the most important factor is length of delinquency. How foreclosures, short sales affect your credit

"By the time most people consider a short sale or foreclosure, their credit has already taken a hit because they have fallen behind in payments," says Craig Watts, a spokesman for FICO, the firm that pioneered credit scoring. "Consumers shouldn't wait until they have delinquent debts to consult with a credit counselor or to call their lender and see what options might be available to them."

Problem widespread
According to RealtyTrac, foreclosure activity jumped 7 percent from June 2009 to July 2009 and 32 percent from a year ago. One in every 355 households with a loan got a foreclosure filing in July 2009, the company reported.

Melissa Monroe of Brentwood, Calif., says her family was hit hard when they couldn't afford the higher payments tied to their adjustable-rate mortgage (ARM) and realized they owed more on their mortgage than their home was currently worth.

"My husband and I didn't realize that when our ARM was reset, it would raise our monthly payment over $400 this year and again next year," Monroe says. "The value of our loan was $389,000, yet homes in our neighborhood were only selling in the mid-$100,000s, if they sell at all."

Monroe has always boasted a credit score of more than 800 and knew a foreclosure would crater her credit rating. She looked into getting a loan modification and conducting a short sale before finally opting to foreclose on her home.

"We were denied a loan modification from our lender because we weren't behind in our payments and our older home would have required significant and costly structural repairs before we could put it on the market for a short sale," Monroe says. "In the end, after consulting with a lawyer and doing a cost-benefit analysis, we decided to foreclose."

Missed payments impact score more
Whether you choose to foreclose on your home or opt for a short sale, the primary factor that will affect your credit score is how far behind you are on your mortgage payments.

"A lot of people are under the misconception that it's the foreclosure or the short sale itself that affects your credit," says Patrick Ritchie, author of "The Credit Road Map." "It's actually the number of months that you've been delinquent on your payments that's going to cause the drop in your credit score." The same is true if you choose to walk away from your home. However, in this case, your credit will be hit hard since you did not attempt to make contact with your lender and after a few months of no response from you, the lender will most likely hire attorneys and sue for foreclosure.

The delinquent payments and foreclosure would be reported to the credit reporting agencies. In addition, the lender may be able to go after other assets and income after the foreclosure if the state in which the property is located allows for deficiency judgments. Not all states allow this, but that's why the experts recommend talking with a credit counselor or bankruptcy attorney to determine the best options before deciding to foreclose or simply walk away from a home.

 MORTGAGE DEFAULT 'CURES'

Homeowners who fall behind in their mortgages and can't catch up have several options, most of them unpleasant.

  • A foreclosure is the proceeding by a creditor to regain a homeowner's property following a default on mortgage payments.
  • In a short sale, the homeowner sells the property, but the proceeds from the sale fall short of the balance owed on a loan. The lender eats the loss to avoid the cost of foreclosure.
  • When a homeowner goes through a loan modification, the terms of the mortgage are modified to reflect lower interest rates, loan terms or loan balances. 
  • A walkaway is what it sounds like: A homeowner who owes more than a house is worth simply leaves. This solution is also called "jingle mail" for the sound that keys make inside an envelope mailed to the lender.
  • In a deed in lieu of foreclosure, the homeowner signs over all interest to a property in default in order to avoid foreclosure.

The credit reporting agency TransUnion released data in August 2009 showing that the number of mortgage holders who are 60 days or more behind on their payments increased for the 10th straight quarter to 5.81 percent nationwide for the three months ending June 30. Experts say if you find yourself contemplating foreclosure or a short sale, consider the following in order to minimize the impact on your credit score:

1. Evaluate your options
"When it comes to foreclosures and short sales, they are both going to weigh the same on your credit rating and drop your credit score 150 to 250 points," Ritchie says. "If you sense that you are going to have problems paying your mortgage, it's best to meet with a credit counselor to explore your options."

"A lot of people wait too long before they come to us for help," says Lisa Mitchell, a certified credit counselor with Consumer Counseling Credit Services in Arcata, Calif. "All too often, we receive calls where the consumer needs help because their home is being foreclosed and being auctioned off next week."

Most credit counselors offer free budgeting workshops and consult with consumers to decide if a loan modification, short sale or foreclosure is the best course.

"If a client is considering foreclosure, chances are they are also battling mounting credit card debt," Mitchell says. "I think people hold off getting assistance because they feel overwhelmed or ashamed and think we may judge them. Our job isn't to judge, but to help them avoid a financial disaster."

2. Protect your interests
While obtaining a loan modification may seem like the best way to protect your credit, the way your lender reports your loan modification will determine the affect on your credit score. If you are reported as being 30 days past due or classified as a "partial payment," it can show up as a negative mark on your credit report. A partial payment score can lower a consumer's FICO score by over 50 points.

"For consumers who are considering a short sale or foreclosure, I also recommend they speak with a tax or bankruptcy attorney to determine any tax liabilities," Ritchie says. "Although the Mortgage Forgiveness Act of 2007 prevents forgiven mortgage debt due to foreclosures, short sales and deeds in lieu of foreclosure from being taxed, there are some exceptions."

Heidi Barnes, a loan consultant with Paradise Financial Group in Pleasant Hill, Calif., says that those who refinanced when the real estate market was booming might be hardest hit. "If you took out a home equity loan for $25,000 and spent it on items other than home improvements, you might find yourself with tax consequences if the bank forgives your debt," she says.

It's much easier to rebuild your credit if the foreclosure or short sale was an isolated incident.

-- Craig Watts
FICO spokesman

3. Ask and you may receive
"Three years ago, no one called their lender to try and modify their loan, but today, we're living in abnormal times, and many people are having housing problems," Watts says. "You have nothing to lose by calling your lender at the first sign of financial problems and letting them know that you still intend to pay, but you want to know what options are available to make your mortgage more affordable."

Since loan modifications are a hot topic, many unethical companies have begun advertising their services to consumers. Beware of companies that offer to modify your loan for a significant upfront fee or who ask consumers to send them their mortgage payments. For information on President Obama's loan modification program, visit makinghomeaffordable.gov. The site also discusses loan modification scams and shows how to contact a HUD-approved housing counselor who can give you a free consultation concerning your individual situation and discuss the options available to you. You can also call the Homeowner's Hope hotline at (888) 995-4673.

4. Begin restoring your credit immediately
While a foreclosure, short sale and delinquent payments will remain on your credit report for seven years, you can and should begin to rebuild your credit score as soon as possible.

If that is the only negative on your credit report, you may be able to rebuild your credit score fairly quickly.

"Any negative on your FICO score is looked at from three different perspectives, including how late were payments made, with 90 days obviously being more severe than 30 days," Watts says. "We also look at how recent is the negative mark, and is this the only time the consumer has had a delinquency. It's much easier to rebuild your credit if the foreclosure or short sale was an isolated incident."

After Monroe foreclosed on her home, she applied for a secured credit card and began immediately rebuilding her credit.

"If consumers re-establish credit and prove they are reliable by making payments on time, they can typically restore their good credit within a couple years after going through a foreclosure or short sale," Watts says.

See related: 10 things you must know about credit reports and credit scores, Learn the ABCs of credit scores, credit scoring

Published: September 2, 2009


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