You can’t really say that credit scores don’t matter. They do.
So it’s understandable that the hundreds of thousands of homeowners who finally realize they can no longer hold onto their homes worry about how turning in their keys to the house through various transactions with their lender will affect their credit scores.
People can just let the home go to foreclosure, and this will affect their scores for seven years. Or they can do a deed in lieu of foreclosure. With a deed in lieu, you voluntarily give your home to the lender in exchange for the cancellation of your loan. This, too, can create a negative mark on your credit history.
Homeowners can also get out from under a mortgage by doing a short sale, in which the lender allows the borrower to sell the house for less than what is owed. A short sale is also bad for your credit.
RealtyTrac recently reported that pre-foreclosure transactions, which often include short sales, jumped 19 percent between the first and second quarter of this year. Short sales accounted for 12 percent of all housing sales in the second quarter, up from 10 percent for the same period last year.
But is there a pecking order in which the ubiquitous credit scoring system treats a short sale more favorably than a foreclosure or a deed in lieu of foreclosure?
I get this question quite often these days. Homeowners have been led to believe that because foreclosure is so devastating to their credit scores, almost anything else is better.
This is not true — turns out there’s no significant difference in FICO score impact among foreclosures, short sales or deeds in lieu of foreclosure, said Bradley Graham, senior director of scores product management at FICO, which is the trademark credit scoring model created by Fair Isaac Corp. It’s the most widely used scoring system in the country.
“All of those events represent a loan default and as such are highly predictive of future credit risk,” Graham wrote in an e-mail.
If you apply for a loan in the future, certain lenders may look more favorably at a short sale than at a foreclosure, but the credit scoring system sees all these defaults as equally bad. Graham said that based on the analysis of the information that lenders share with credit bureaus about those forms of mortgage default, they have about the same weight when determining future risk.
There are two caveats in what lenders report to the credit bureaus, Graham said. The negative impact of a foreclosure, short sale or deed in lieu of foreclosure can be slightly less if the lender does not report a deficiency balance. A deficiency balance is the amount one may owe the bank after a property is sold.
In a blog posting this year, Fair Isaac illustrated the relative score impact for different consumers who experience a mortgage delinquency or foreclosure/short sale/deed in lieu. To find the chart, go to bankinganalyticsblog.fico.com and search for “Research looks at how mortgage delinquencies affect scores.”
Here’s something interesting: The FICO analysis found that the higher your original score, the greater the drop and the longer it will take for your credit to recover to the same level assuming all else held constant. A consumer who started with a 780 score and did a short sale with no deficiency balance could see his score drop to a range of 655 to 675. The FICO scale goes from a low of 300 to a high of 850. A consumer who started with a score of 680 could see a drop to a range of 610 to 630.
For the consumer with the original 780 score, it could take seven years to get back to that level. But at 680, it could take just three years.
So how would a loan modification affect your score?
Credit reports show limited information about mortgages, such as balance, date opened, payment history and current status. The information reported does not show loan terms such as interest rate, monthly payment or number of months remaining on the loan. If a mortgage modification changes only the interest rate, the years remaining on the loan and/or the amount of the borrower’s monthly payment, those changes will not be reflected on the credit report and can’t affect the person’s credit score, Graham said.
At least now you know that if you decide you can’t keep your house, you don’t have to fret that one way to turn in your keys is far worse than the other. So just weigh what’s best for your overall situation and not only the impact to your credit score, Graham said. “The FICO score is only one part of anyone’s credit profile and reputation.”
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