These days, many Americans are considering foreclosure, whether by necessity or choice. Mortgage default and its alternatives can have varying effects on a borrower's ability to secure credit in the future. Unfortunately, credit scoring tends to be a very mysterious black box, leaving many homeowners unsure what option is best for their credit. But a conversation with one of FICO's principal scientists, Frederic Huynh, revealed some helpful information that could help struggling borrowers to understand how various decisions might affect their credit score.
Prime Borrowers Have More to Lose
It's very difficult to make generalized statements about how actions would affect a broad cross-section of credit scores. But there is one truism that stands out: the higher the score, the bigger the impact of a negative event. The flipside, however, also holds true: the lower the score, the smaller the effect of a new blemish.
Whenever an event occurs that may affect your credit score, the servicer handling your account will notify the credit rating agencies. That goes for good and bad events. Yet, reporting is more an art than a science: not all servicers report the same actions in the same way. So what follows assumes that the servicer is reporting the event as indicated. This may not always be the case.
A Foreclosure By Any Other Name. . .
If you're a homeowner having difficulty paying your mortgage, you may be considering going delinquent or defaulting. You know that would be bad for your credit record. What is your best alternative?
A bank foreclosing on a defaulted mortgage is a common path for struggling borrowers. This will have a negative effect on your credit score. FICO has said that this would result in a borrower with a 780 credit score see her score drop between 140 and 160 points. With a credit score of 680, the hit would be between 85 and 105 points. Yesterday, FICO said that in most cases at least 50 points would be lost due to foreclosure.
One alternative is a so-called "deed-in-lieu." This alternative occurs when you willingly hand over your keys to the bank, so to avoid formal foreclosure proceedings. This might be logistically easier, but it's not any better for your credit score. According to FICO, a deed-in-lieu would cause a similar drop in your credit score as foreclosure.
Short sale is also an option. A short sale occurs when you find someone to buy your home for less than the unpaid balance of your mortgage. The bank may approve this short sale, but it may still inform the credit agencies of your failure to pay. In that case, short sale would have a similar affect on your credit score as foreclosure, according to FICO.
Remember: reporting matters. If the servicer chooses not to report the short sale as a default, then your score will be unaffected. If it reports only the portion of the balance unpaid as defaulted, then that could also help, since bigger defaults cause more harm to a credit score. But if it reports the short sale as a default for the full mortgage balance, then your score will decline by as much as it would have through foreclosure.
You might think that modifying a mortgage would be better for your credit score than foreclosure, but according to FICO that's not necessarily true. If the servicer indicates that the debt was modified to accommodate a new payment plan, then it would have a similar negative effect on your credit score as foreclosure.
Work With Uncle Sam
There is, however, an exception to that last point. Modification won't affect your credit score if done through the government's HAMP mortgage modification program. FICO has created a special code for these actions that indicate the loan was "modified under federal government plan." Currently, this will not impact on your credit score. In the future, however, this luxury could change, if FICO determines that participation in the government plan strongly suggest future credit trouble.
Of course, if servicers don't properly report your modification by using that special new code, then your score could still suffer. But according to the U.S. Treasury, participating servicers are required to report this code to the credit rating agencies.
The Obama administration also announced a new mortgage payment deferral program for unemployed Americans last week. How does this affect a borrower's credit score? It doesn't, according to FICO. An approved deferral is not treated as a negative credit event.
Second liens also plague many struggling homeowners. Here, there's good news and bad news. The good news is that a second lien's default has a marginal effect on your credit score compared to foreclosure, according to FICO. The bad news, however, is that it does have an effect.
If you're a struggling homeowner trying to determine which option would affect your credit score least adversely, there are three important points to remember. First, your best, safest, option is to keep paying. This is the only way you can ensure your credit score remains intact. Second, if you can't pay, then try to work with the government's foreclosure prevention program. At this point, a modification through that program will not impact your credit score, though that could change in the future. Finally, try to understand how your servicer will report whatever actions you are considering. Getting them to explain how different events will be reported might not be easy, but it's certainly worth trying.