Recently I read an article about not only changes being made in the mortgage industry, but also how those potential changes might affect credit scores. Since the article lists some credit “facts”, I feel obligated to address it further. The article is short so I have listed it here and will follow up with a few opinions after:
Nondelinquent Borrowers Soon to Be Eligible for Short Sales
Daily Real Estate News | Wednesday, October 24, 2012
Mortgage giants Fannie Mae and Freddie Mac have issued new rules, which will take effect Nov. 1 that will allow short sales for underwater borrowers who have never missed a mortgage payment. Previously, Fannie and Freddie allowed only home owners who had missed payments to qualify for a short sale.
Eligible borrowers under the new rules will need to show a hardship to qualify for a short sale, however. Hardships may include unemployment or a death of a spouse.
Inman News points out one potential flaw to the new rule, however: The nondelinquent home owners who undergo a short sale will likely take just as big a hit to their credit score than if they had missed loan payments and gone into a foreclosure.
“Under current national credit reporting practices, those nondelinquent borrowers are likely to be treated the same for credit scoring purposes as severely delinquent owners who go to foreclosure after months of nonpayment, or who simply toss back the house keys and walk away in strategic defaults,” writes Ken Harney for Inman News.
Credit agencies use no special coding to indicate that a short sale was without delinquency. Therefore, home owners could see their credit scores drop 150 points or more after the short sale.
However, officials at the Federal Housing Finance Agency, which oversees Fannie and Freddie, told Inman News they are “in discussions with the credit industry” to explore ways to fix the credit score problem for those who haven’t missed a payment but undergo a short sale.
The good news is that when the new rule change goes into effect, this will now give people an even greater incentive to take this course of action rather than just allowing the property to be foreclosed on.
The bad news is a few of the credit facts listed in this article are wrong or at best misinterpreted. With all due respect to Mr. Harney, who is a much esteemed writer, I believe the source of where some of his credit information came from was a little off, specifically paragraph 3 and his quote following that in paragraph 4.
To completely understand the debate about short sales vs. foreclosures and more specifically the impact on the FICO score we need to understand a few things.
First -what happens prior to the closing/sale date?
With a foreclosure we know that the person will have multiple late payments listed on the credit report for that account. With a short sale (especially with this new rule) there doesn’t have to be any late payments. This is great news because the absence of 30, 60, 90+ day late payments on an account is better for your FICO score than if those were present on the account history. One of the biggest arguments that people used to have is that it was basically impossible to get a short sale negotiated without being delinquent first. Now with this new change that issue should be eliminated.
For this reason, if a person does not become delinquent on the mortgage prior to the short sale being completed this action would be better for the FICO score than a foreclosure.
Advantage- short sale
Second- what happens after the closing?
When there’s a foreclosure the account will be listed as such or it will say “charged off account.” Any derivative of this is bad and will hurt the FICO score. With a short sale the article is correct; there is no special way that a lender can mark the account as a short sale. Since that is not an option the lenders have the choice of how they report it. Most commonly lenders report it as “settled for less than full” which in the eyes of your FICO score all means the same… it is bad! With that being said, since a short sale is not an option for credit reporting, the one wild card that can come into play is if the lender just simply marks the account as “paid”. If this were to happen it would be much better than being reported as a foreclosure.
Advantage- short sale
The last part of this debate hasn’t been covered. Not only is the FICO score measuring how delinquent someone’s account is, it’s also measuring the time since that incident. Meaning the older that negative is, the less it hurts your score. With a short sale you can help to speed up the process, which will help an individual’s FICO score recover quicker.
Overall if this new rule does in fact come into play it is a positive thing for struggling homeowners that need to get out from under a property they can no longer afford. Keep in mind homeowners also want to do everything they can to lessen the credit score damages that will become associated with any of these actions.