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How does a Short Sale Affect Your Credit

December 12, 2009

Homeowners who cannot pay the mortgage may be desperate to get rid of their obligation. Depending on their situation they may have a few options available to them: refinance, loan modification, short sale, foreclosure or bankruptcy.

Lenders report these transactions to credit bureaus. In many cases, a mortgage solution significantly damages the borrower’s credit score, also known as the FICO score.

“The single worst thing any person can do to her FICO score is to have a serious delinquency such as foreclosure or bankruptcy appear on her credit bureau report,” says Craig Watts, public relations director for FICO, which developed the FICO score.

Damaged credit can make life miserable for borrowers, making it more difficult to secure a future mortgage or other loan, rent an apartment or even get a job.

A mortgage solution’s potential to damage a credit score depends on a borrower’s individual financial circumstances and past credit history, Watts says.

“The impact that serious delinquencies have on FICO scores can vary from person to person, based on what other information is on the person’s credit bureau report,” he says.

Watts says that FICO 08, a revamping of the credit score formula, will not alter how mortgage solutions affect a borrower’s credit score.

“As have all our previous updates to the formula, our FICO 08 formula gives appropriate weight to consumer credit information — including foreclosures — based on the way consumers have handled credit obligations recently,” Watts says.

Foreclosure and bankruptcyA foreclosure can make a significant negative impact on a borrower’s score.

Attorney Michael Hollman, with Village Settlements in Gaithersburg, Md., says he’s seen as much as a 300-point drop in the FICO scores of clients who have a foreclosure listed on their credit reports.

A foreclosure will remain on a credit report for seven years, according to FICO’s  myFICO Web site. However, a FICO score may begin to rebound in as little as two years if the borrower keeps all other credit obligations in good standing, according to the site.

According to the Web site, “The important thing to keep in mind is that a foreclosure is a single negative item, and if you keep this item isolated, it will be much less damaging to your FICO score than if you had a foreclosure in addition to defaulting on other credit obligations.” 

Some homeowners who face foreclosure may turn to the bankruptcy process for help. According to the National Consumer Law Center in Boston, a bankruptcy may make it possible to stop the foreclosure process, allowing borrowers to catch up on missed payments.

Travis Hamel Olsen, president of the National Short Sale Center in Scottsdale, Ariz., says borrowers also can use bankruptcy to discharge other debts, freeing up money for the monthly mortgage payment.

However, the reality is that in many cases, a bankruptcy just buys time until the homeowner defaults again on the loan, Olsen says.

In addition, a bankruptcy may have a greater negative impact on a borrower’s FICO score than a foreclosure, according to the myFICO Web site.”While a foreclosure is a single account that you default on, declaring bankruptcy has the opportunity to affect multiple accounts and therefore has potential to have a greater negative impact on your FICO score”.  

A bankruptcy remains on a credit report for seven to 10 years, depending on the nature of the bankruptcy.

Bankruptcy is not the only alternative to foreclosure and a preferred alternative is a short sale. A short sale which occurs when a lender agrees to allow a homeowner to sell a property for less than what the owner still owes on the mortgage.

A deed in lieu of a foreclosure is another alternative. It occurs when homeowners deed their home to the bank without going through the extra time and cost of a lengthy foreclosure process.

Homeowners can only qualify for a deed in lieu of foreclosure if they have just one mortgage or if they have multiple liens from the same lender. Banks require that the homeowner attempt a short sale before they will agree to accept a deed in lieu.

A short sale is less damaging to a homeowner’s credit score than a traditional foreclosure.  Credit bureau reports are limited in how they report and foreclosures are represented as such while short sales are represented as settled accounts.

While foreclosures and their alternatives are all treated as “serious delinquencies” on a credit report, however, one significant advantage of a short sale is that as part of sale negotiations, homeowners can ask the lender to report to the credit bureaus that the mortgage has been paid in full.

“A lot depends on how the bank reports a short sale,” Olsen says. “Most often, it will be reported as a ’settled debt’ but it can even be listed as ‘paid in full’ by some lenders.”

Even if the borrower can win this concession, some credit damage may already have occurred in the months leading up to the short sale, says Jacob Benaroya, president and managing partner of the Biltmore Capital Group, buyers and sellers of nonperforming mortgage loans based in Rochelle Park, N.J.

“The lender is likely to have reported late or missing payments to the credit bureau, so homeowners may find that their credit score has been damaged even before a short sale takes place,” Benaroya says.

Two other techniques often used to stave off foreclosures include loan modifications and refinances. Loan modifications have proven to be extremely frustrating and highly ineffective as even if the bank(s) agree to modify the loan(s), which is extremely rare, the terms of these modifications are favorable to the lender and force the overwhelming majority of homeowners back into default in less that 90 days. Furthermore, refinancing is rarely an option for most owners as their homes have depreciated and are no longer worth what they originally paid for them and thus the banks will not provide new financing.

Many people  think they don’t want to do a short sale because they may owe money later in the form of a deficiency judgement for the difference the amount that is actually owed on the mortgage and the amount collected through the short sale. What they need to understand is that a deficiency judgment is part of the short sale negotiations and it is their Realtors charge to get the bank to agree in writing to accept the short payoff as payment in full and agree not to pursue the homeowner for the deficiency.

To avoid a deficiency judgment related to a short sale, borrowers should be careful to have a written agreement from the lender that says the sale represents a “total satisfaction of debt”.

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