How will Foreclosure Affect my Credit Score?
In yesterday’s post, I expounded upon a new trend in the foreclosure crisis – the “strategic default” – whereby underwater borrowers deliberately make a calculated decision to stop making payments on their mortgage. “Current lending practices have created an environment where a measure as extreme as abandoning a home actually makes sense to some people. Many buyers put little or no money down, so they don’t have much invested in them. That leaves them with little incentive to keep making payments when a home’s market value dips below the balance of the mortgage.” With today’s post, I intend to develop this thread further to explain how default (strategic or otherwise) affects one’s credit score.
It turns out that this impact is relatively modest, especially when you compare it to continuing to make payments on a mortgage that well exceeds the value of one’s home. Obviously, borrowers can expect to see their credit rating deteriorate overnight, by a significant margin – as much as 200 points. In addition, it will be nearly impossible for one to take out a new mortgage (or any other significant loans, for that matter) for at least a couple years. The exact duration depends on many factors, namely the borrower’s credit score at the time of default. Ironically, “The higher the score, the greater the damage.”
However, the credit scoring system is such that continuing to make mortgage payments in lieu of payments on other debt instruments (such as credit cards and auto loans) might actually be more detrimental in the long run. ” ‘While a mortgage default can savage a person’s credit record, trying to pay off a loan they can’t afford could be worse for borrowers if it leads to bankruptcy,’ ” said one source. “Credit scores are hurt much more by missing multiple payments – on credit cards, cars and so on – than by a single foreclosure.” In other words, it would take longer for your credit to heal (i.e. a longer wait before you could take out a new mortgage) if you declared bankruptcy, than if you defaulted on your mortgage, even though the Dollar amount of the latter is in most cases much larger than the former.
What about the alternatives? A short sale is now an increasingly attractive option for many borrowers, “thanks to the Mortgage Debt Relief Act of 2007. Previously, if a bank sold a foreclosed home for less than the mortgage balance and it forgave the difference, the borrower had to pay tax on that difference as if it were income. Now the IRS will ignore it.” Even though short sales don’t show up directly on one’s credit report, they are still incorporated into the credit score as a negative event.
The same goes goes for a deed in lieu of foreclosure, in which “the borrower turns over the deed to the property to avoid foreclosure and settle the debt.” While such can help one avoid the delinquent payments normally associated with foreclosure, the deed itself will still show up on the report. According to one source, the logic that one of these choices is better than the other is just plain wrong: ” ‘Someone out there is passing along a rumor that a short sale is better for your credit than a foreclosure or even a deed in lieu of foreclosure,’ he said. ‘All are equal in the eyes of FICO.’ ”
Even loan modification can negatively impact one’s credit. One would think that by preemptively contacting one’s lender (especially before the mortgage becomes delinquent) would receive favorable treatment in the eyes of credit scoring agencies. Unfortunately, their rubrics assume that modified loans are more likely to result in default: “We view an account that has been settled or renegotiated for less than the full amount as a negative because historically consumers on reduced payment plans represent a greater risk,” explained one expert. While loan modifications are generally less punitive than foreclosures, the credit hit can still be significant. It’s no wonder some borrowers are electing to simply walk away.