Written By: Linda Ferrari, President of Credit Resource Corporation, a consulting firm with offices in Los Angeles and Orange County, California. They work with Lenders, Mortgage Brokers and Realtors across the nation to help borrowers with less than perfect credit scores increase their chances for loan approval. Please feel free to browse CRC’s site at www.CreditResourceCorp.com to access some very helpful tips on improving and managing credit scores. Hire Linda to speak at your next event - MortgageSpeakersBureau.com.
Order a copy of Linda's new book The Big Score: Getting It and Keeping It, Buying Power for Life.
"Is it better to go through foreclosure or short sale?"
"What is a short sale and how will it affect my credit?"
"I'm upside down in my mortgage. What's going to happen to my credit?
As an expert on the credit scoring system, these questions are asked of me every day by frightened homeowners and mortgage professionals who are quickly trying to respond to the financial chaos that arises from the sub prime mortgage crisis.
Finding that dream home and signing off on the deal brings a rush of exhilaration. Many consumers get caught up in the excitement of it all, and they forget to consider what might happen if they can't make their mortgage payments. Right now, our nation's economy faces an enormous challenge as hundreds of thousands, if not millions, of families are staring down the decision of which path to take. And their biggest question now is how to most effectively do so without devastating their credit scores so they will someday be able to buy a home again.
I speak to families every day, and I take heart by those who have the wisdom and emotional strength to face these tough issues head on! They will be served well by their courage, and their credit scores will be better off for it!
Now is the time for tough questions to be asked and answered.
Foreclosure, Deed in Lieu of Foreclosure, Short Sale, Loan Modification and Bankruptcy can have long-lasting affects on an individual's credit. Homeowners need to get the facts before making critical decisions that will impact their lives for many years to come.
Here is a breakdown of homeowner options, and how each affects the credit scores:
Foreclosure
Foreclosure is the legal process in which a bank or other secured creditor either sells or repossesses a parcel of real property, home or land, after the owner has failed to comply with the mortgage or deed of trust agreement with the lender. Most frequently, the violation of the mortgage agreement is the default of payment. The completion of the foreclosure process allows the lender to sell the property, and keep the proceeds to pay off the mortgage as well as any legal costs. The length of the foreclosure process varies from state to state.
If the foreclosed property is sold for less than the remaining primary mortgage balance, and there is no insurance to cover the loss, the court overseeing the foreclosure process may enter a deficiency judgment against the borrower. Deficiency judgments can be used to place a lien on the borrower's other personal property, obligating the borrower to repay the difference or suffer the loss of their property. It gives the lender a legal right to collect the remainder of debt out of the borrower's other existing assets.
However, there are exceptions to this rule. If the mortgage is classified as "non-recourse debt," then the borrower has no personal liability in the event of foreclosure. This is often the case with residential mortgages. If so, the lender may not go after borrower's personal assets to recoup additional loss.
The lender's ability to pursue a deficiency judgment can be restricted by state laws. In California and some other states, original mortgages (the ones taken out at the time of purchase) are typically non-recourse loans, however, refinanced loans and home equity lines of credit are not.
If the lender chooses not to pursue deficiency judgment-or can't because the mortgage is non-recourse-and writes off the loss, the borrower may have to pay income taxes on the unrecovered amount if it can be considered "forgiven debt."
Any other loans taken out against the property being foreclosed (second mortgages, HELOCs) are "wiped out" by foreclosure (in the sense that they are no longer attached to the property), but the borrower is still obligated to pay them off if they are not paid out of the foreclosure auction's proceeds.
How Does a Foreclosure Affect a Credit Score?
A foreclosure will make a score drop immediately by 100-250 points. It all depends on how many points a consumer has to lose in the payment history factor, which is worth 297.5 points. It is a very serious derogatory mark, indicating that the borrower is walking away from their financial responsibilities without concern for consequences. It is treated similar to a Chapter 7 bankruptcy in that the requirements of the lender state that they will not give home loans to consumers who have had a foreclosure within the last 2-5 years. So a borrower who forecloses on a mortgage is immediately penalized by the drop in the credit score, but will also be denied credit for any new loans for a period of time. The actual amount of time before the borrower can qualify for a new loan depends on the specific circumstances that caused the foreclosure. Job loss, financial crisis or a medical crisis are factors to be considered.
When it comes to foreclosure and how it affects the ability to obtain credit in the future, there are multiple points of extremely negative impact. Deficiency judgments for the amount not collected by the lender in the foreclosure sale can end up on the borrower's credit report as a derogatory mark. Additionally, there is a high risk that the borrower will be hit with a substantial tax penalty which can result in a tax lien, which also appears on the credit report. As a general rule, foreclosure is the least desirable of all of the options available when a borrower is upside down in a home mortgage.
Deed in Lieu of Foreclosure
One option to foreclosure is a "deed in lieu of foreclosure." In this scenario, the borrower turns the house over to the lender and walks away without owing anything. A deed in lieu of foreclosure offers several advantages to both the borrower and the lender. The main advantage to the borrower is that it immediately releases him or her from most or all of the personal debt associated with the defaulted loan. The borrower also avoids a foreclosure proceeding and may receive more generous terms than he or she would in a formal foreclosure. Advantages to a lender include a reduction in the time and cost of repossessing the property.
In most instances, in order to be considered for a deed in lieu of foreclosure, the total debt on the property should be secured by the real estate being transferred. Both sides must enter into the transaction voluntarily and in good faith. The settlement offer must at least be equal to the fair market value of the property being turned over. Generally, the lender will not proceed with a deed in lieu of foreclosure if the outstanding debt on the property exceeds the current fair market value of the property.
Because the agreement must be voluntary, lenders will often not act upon a deed in lieu of foreclosure unless they receive a written offer from the borrower that specifically states that the offer to enter into negotiations is being made voluntarily. This will enact the parol evidence rule and protect the lender from a possible subsequent claim that the lender acted in bad faith or pressured the borrower into the settlement. Both sides may then proceed with settlement negotiations.
Neither the borrower nor the lender is obliged to proceed with the deed in lieu of foreclosure until a final agreement is reached.
How Does a Deed in Lieu of Foreclosure Affect the Borrower's Credit?
It all depends on how the lender reports the account to the credit bureaus. Most lenders report a deed in lieu of foreclosure as a foreclosure, so the credit scores will carry the same serious affect as if it were an actual foreclosure. However, what most borrowers don't know is that they can negotiate with the lender to report it differently.
Many lenders will say that they cannot change the reporting status, but they can. Here are their options in preferred order:
- Paid - Won't hurt the score at all
- Unrated - May drop a few points
- Paid Settlement - May hurt the score by 50-100 points
The borrower can also talk to the lender about not holding him or her liable for the deficiency, if there is one when the home is sold.
Short Sale
In real estate, a short sale occurs when a bank or mortgage lender agrees to discount a loan balance, due to an economic hardship on the part of the home owner. The home owner sells the mortgaged property for less than the outstanding balance of the loan, and turns over the proceeds of the sale to the lender in full satisfaction of the debt. In such instances, the lender would have the right to approve or disapprove a proposed sale.
Certain extenuating circumstances influence whether or not banks will discount a loan balance. These circumstances are usually related to the current real estate market climate and the individual borrower's financial situation.
A short sale is typically executed to prevent a home foreclosure. Lenders often choose to allow a short sale if they believe that it will result in a smaller financial loss than foreclosing. For the home owner, the advantage includes avoidance of having a foreclosure on their credit history. Additionally, a short sale is typically faster and less expensive than a foreclosure.
The Mortgage Forgiveness Debt Relieft Act of 2007
When the lender decides to forgive all or a portion of the debt and accept less, the forgiven amount is considered as income for the borrower, leaving it open to be taxed. However, The Mortgage Forgiveness Debt Relief Act of 2007 contains amendments to remove such tax liability, allowing the borrower and lender to work together to find a solution beneficial to both parties.
How Does a Short Sale Affect the Borrower's Credit?
It is not common for short sales to be reported to bureaus. In fact, in the tens of thousands of files I have reviewed, I have seen very few short sales appear on them. The few that I have seen have appeared as "Paid Settlements" on a mortgage account. In the wake of the current mortgage crisis, short sales are becoming extremely common, but legislation has not caught up with the tidal wave and there is no law on the books relating to them to date. As a result, it is currently up to the borrower to negotiate credit reporting with the lender.
Here are the primary items for considering whether a short sale is the best course of action:
- According to the Mortgage Relief Act of 2007, the borrower and lender can work freely together to find a common solution that is beneficial to both the parties. In my mind, that language indicates that the consumer can negotiate with the lender to NOT report the item to the bureaus at all. I have seen borrowers negotiate these terms with great success.
- In the past, a foreclosure was the worst derogatory mark that could result from a mortgage loan default. This is rapidly changing, however. Recent loan requirements released by Fannie Mae and Freddie Mac state that they will consider a short sale as being the same as a foreclosure. In doing so, they will not purchase loans if the current borrower has had a short sale in the last 2-5 years. I find this stringent requirement to be completely unfair because as previously stated, a short sale proves that the borrower is exhausting every effort to pay the loan. The borrower has willingly committed to taking on months of emotional and physical stress in a good-faith effort to sell the property. The stricter requirements lead me to ask why lenders would want to report short sales on clients who are making an effort to pay the loan? If Fannie Mae will not approve loans for such clients for the next two to five years, it appears that lenders could be cutting off a pretty substantial future income stream if they cannot sell loans to the vast numbers of people who are now in trouble. This might create quite the incentive for lenders to work with borrowers to keep the short sale off the records. In that light, negotiation for a non-report on short sales is well worth it.
- If a short sale is going to be reported, you must insist that it is reported as a "paid settlement." A paid settlement will cost the borrower anywhere from 50-100 points, again depending on all other elements on their credit reports. However, it is much easier to recover from a paid settlement than from a foreclosure or bankruptcy.
Bankruptcy Mortgage Relief
Currently, bankruptcy offers very limited protection to a homeowner who is upside down with their payments. The borrower can file a Chapter 7 which, depending on the state bankruptcy law, will most likely require him or her to surrender the property to the bankruptcy court, or file a Chapter 13 debt repayment plan to spread out prior delinquent payments over a number of months or years in the future. However, no bankruptcy proceeding can modify the terms of an existing home loan on a principal residence. Legislation is being proposed to Congress that would allow bankruptcy judges to modify the terms of an existing mortgage loan. I would not hold my breath. It could take years to make further substantial changes to the bankruptcy laws.
Which is The Best Choice to Protect Credit Scores?
Each of the scenarios I have presented in this article have a specific impact on credit scores. I can show how each alternative affects an individual's scores, but it's important that each individual understands that this is a very personal decision. A borrower must weigh out the impact that such a critical decision will have on family, employment and future financial stability.
But above all, consumers should not be afraid to ask questions and find out what options are available. Many consumers mistakenly assume that there are specific laws and policies set in place that govern the actions of lenders, creditors, and credit bureaus. However, they are in the grey as much as the consumer is, in many instances. So home owners in trouble should not feel intimated by them. If a plan sounds logical, then the borrower should do the research, lay out the plan, and then present it to the lender. With so many Americans in trouble, this is a time when real solutions are necessary to our economy. By creating solutions, there is a chance we can bring about changes in legislation that can help millions of consumers.
In Conclusion:
I have spent many years in the credit business. I have seen a lot of devastation to scores, the result of economic crisis. I have never witnessed such a dramatic impact across a wide cross-section of people as I have seen recently. It is trying the hearts, minds, and financial futures of literally millions of individuals. On a daily basis, I suffer heartbreak as I speak with countless individuals who have abandoned their last hope of salvaging their home ownership, and now fight to save their credit. They are strong, and they will overcome this struggle because they are proactive, they are wise, and they know that they can take steps to mitigate the damage and recover to come back stronger than ever.
My advice to any home owner on the verge of foreclosure is, first and foremost, find out what options are available. Do the research. Consult the experts. Gather as much information as possible, and weigh out the pros and cons. Make an educated decision, because what may seem to be the best answer for right now could also have a serious impact for many years to come.
The great news is that whatever decision is made, whatever fate falls upon their credit scores right now, they can start improving their credit situation immediately. Go to www.creditresourcecorp.com for some great tips on how to rebuild and re-establish credit.
Copyright - 2008 - LoanOfficerMagazine.com
Read More
