The recent economic crisis has paralyzed the hopes and futures of millions of homeowners who are now wondering how they will recover and rebuild in one of the most stringent lending environments on record. How will they manage their credit through the turbulent economic and financial strangleholds in which they find themselves trapped? Is there relief? Is there any salvaging of the housing market? What is the best path for consumers to get there?
There’s no question that many families will still have to leave their homes. Their biggest question now is how to most effectively do so (without devastating their credit scores) so that they will someday be able to buy a home again.
Now is the time for tough questions to be asked and answered.
Note: The guidelines which are referred to in this report are the selling guidelines of Fannie Mae & Freddie Mac, the two companies (recently taken over by the U.S. government) that own or guarantee about half of the U.S.'s mortgages. These companies base their decisions to purchase mortgage loans on guidelines that are national policy. These guidelines mandate specific credit requirements and policies with respect to problematic situations such as foreclosures, deed in lieu of foreclosures, short sale, or bankruptcy. Specifically, a demonstration of an impeccable credit history must be shown for a designated period of time after the negative event has occurred.
There Are No Requirements On Lenders To Report Negative Information
When it comes to how a lender will report to the credit bureaus, I bring this to your attention as moral support in consumer efforts to NEGOTIATE, NEGOTIATE, NEGOTIATE.
The Fair Credit Reporting Act clearly states that creditors are NOT required to report negative information to the credit bureaus.
There’s more to this story, however. An August 13, 2008 Announcement from Fannie Mae & Freddie Mac clearly states that they place NO requirement on how lenders report mortgage default accounts to the credit bureaus. In response to the frequently asked question about how these items should appear on the credit report, the announcement stated:
“For reporting these actions on Fannie Mae loans, we require that servicers report to one of the major credit reporting agencies, but it is our policy NOT to direct specifically how to report various actions.”
This is powerful and significant information. If the Fair Credit Reporting Act doesn’t require lenders to report negative information at all, or in a specific manner, and the nation’s largest buyer of mortgage loans does not require lenders to report negative information at all, or in a specific manner, this leaves the door wide open for negotiating deletions or non-reporting of these items. So I reiterate: NEGOTIATE, NEGOTIATE, NEGOTIATE.
You May Have Extenuating Circumstances & Not Know It!
In most cases, homeowners who are facing mortgage default will at some point want to purchase a new home, however, there are specific waiting periods put into place to make sure that consumers have enough time to rebuild and re-established good credit. The good news is that for consumers who are being forced into mortgage default due to extenuating circumstances, those waiting periods are reduced.
Here is the definition of Extenuating Circumstances as it appears in the 2010 Fannie Mae & Freddie Mac Guidelines:
Extenuating circumstances are nonrecurring events that are beyond the borrower’s control that result in a sudden, significant, and prolonged reduction in income or a catastrophic increase in financial obligations.
If a borrower claims that derogatory information is the result of extenuating circumstances, the lender must substantiate the borrower’s claim. Examples of documentation that can be used to support extenuating circumstances include documents that confirm the event (such as a copy of a divorce decree, medical reports or bills, notice of job layoff, job severance papers, etc.) and documents that illustrate factors that contributed to the borrower’s inability to resolve the problems that resulted from the event (such as a copy of insurance papers or claim settlements, property listing agreements, lease agreements, tax returns (covering the periods prior to, during, and after a loss of employment), etc.).
The lender must obtain a letter from the borrower explaining the relevance of the documentation. The letter must support the claims of extenuating circumstances, confirm the nature of the event that led to the bankruptcy or foreclosure-related action, and illustrate the borrower had no reasonable options other than to default on their financial obligations.
Homeowner Options & How They Affect Credit Scores
Foreclosure, Deed in Lieu of Foreclosure, Short Sale, and Bankruptcy can all have long-lasting impact on an individual’s taxes and ability to obtain credit. Homeowners need to get the facts before making critical decisions that will impact their lives for many years to come.
The following is a breakdown of homeowner options, and how each affects the credit scores. There are several loan products available, but, as previously mentioned, Fannie Mae & Freddie Mac own or guarantee about half of the U.S.'s mortgage market, so it is best to use their most recent Selling Guidelines as laid out in their June 25, 2008 Announcement.
Foreclosure
Foreclosure is the legal process by 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 one’s 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 in the event of foreclosure the borrower has no personal liability. This is often the case with residential mortgages. If so, the lender may not go after the 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 un-repaid amount even if it can be considered "forgiven debt."
Any other loans taken out against the property being foreclosed (second mortgages, home equity lines of credit) 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 Credit?
A foreclosure can be reported as a Foreclosure or Repossession and carries the most negative penalty on a credit score just under a public record (i.e. bankruptcy, tax lien, or judgment.) There is a misconception that foreclosures are considered public records to the scoring system. However, they are not. Although there is a Public Notice Record on file once a foreclosure is started, this record is completely different than a credit report public record.
Unless a foreclosure becomes a public record, such as a judgment, it can only be reported on a credit report for 7½ years from the date of the first late pay that led to foreclosure. Many consumers and lenders believe that it is 7 years from the completion date of the foreclosure process, but that is inaccurate. A foreclosure falls under the same rules as a collection, charge-off, or other similar action.
A foreclosure can drop credit scores from 50-250 points (this includes points already lost due to delinquent payments). The difference in point loss depends on how many points someone has to lose in the payment history factor of his or her credit report. Thus if someone has a 750 credit score and they opt to foreclose, their score could drop up to 250 points. However, if someone has a 500 credit score, they may only lose 50 points for the same derogatory.
If a deficiency judgment or tax lien is filed in connection with a foreclosure, credit scores can drop an additional 100 points.
How Long Before You Can Buy Another Home After Foreclosure?
The current guidelines from Fannie Mae & Freddie Mac state that the waiting period for a foreclosure is 5 years from the date the foreclosure proceeding is completed.
However, if extenuating circumstances caused the borrower to enter into a foreclosure proceeding, such as the sub prime mortgage crisis fallout, loss of employment or a severe medical crisis, the waiting period, if approved, is 3 years from the date the foreclosure proceeding is completed.
In General: 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 a 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, other than a bankruptcy, 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 obtain 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 parole 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?
Most lenders report a deed in lieu of foreclosure as a foreclosure, so the credit scores will carry the same serious effect as if it were an actual foreclosure. However, borrowers can negotiate with the lender to report it differently in return for turning over the deed and avoiding foreclosure costs.
Many lenders will say that they cannot change the reporting status, but as you now realize, they can. Here are the credit reporting options in preferred order:
- Paid As Agreed - Credit scores will have already dropped over 100 points due to default in payments; however, if reported as Paid As Agreed, the borrower will be able to purchase another home in a shorter time period.
- Paid Settlement - Credit scores could drop up to 100 points in addition to the points already lost for delinquent payments.
- Foreclosure - See above.
How Long Before You Can Buy Another Home After Deed In Lieu Of Foreclosure
The current guidelines from Fannie Mae & Freddie Mac state that the waiting period for a Deed in Lieu of Foreclosure is 4 years from the date the proceeding is completed.
If there are extenuating circumstances that caused the borrower to have to enter into a Deed In Lieu of Foreclosure proceeding, the waiting period is 2 years from the date the proceeding is completed.
Short Sale (aka: Pre-Foreclosure Sale)
In real estate, a short sale is when a bank or mortgage lender agrees to discount a loan balance due to an economic hardship on the part of the homeowner. The homeowner 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 of a proposed sale.
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 homeowner, the advantages include avoidance of having a foreclosure on their credit history. Additionally, a short sale is typically faster and less expensive than a foreclosure.
How Does Short Sale Affect the Borrower’s Credit?
The short sales that I have seen on credit reports 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, there is an opportunity for the borrower to negotiate credit reporting with the lender. I've seen several successful negotiations, so be sure to let your borrower know that it is possible.
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 to maintain a good relationship with that lender. Most likely, the reason they can't afford their current mortgage is because they were in an adjustable product and their mortgage payment has doubled. That doesn't mean that they can't afford a different loan program with a lower payment. There is no incentive for lenders to NOT negotiate with the borrower on how the item is reported to the bureaus. All they would be doing is cutting off a pretty substantial future income stream if they put these types of borrowers out of the market for two years. In that light, negotiation for a non-report on short sales is well worth it.
Here are the credit reporting options in preferred order:
- Paid As Agreed or Paid - Won't hurt the score at all as long as the borrower has kept payments current.
- Unrated - May drop a few points.
- Paid Settlement - Credit scores will drop 50-150 points.
If reported as a paid settlement, the item will remain on the credit report for 7½ years from the date of the first late pay that led to the paid settlement.
How Long Before You Can Buy Another Home After A Short Sale?
The current guidelines from Fannie Mae & Freddie Mac state that the waiting period for a Short Sale is 2 years from the date the Short Sale proceeding is completed There is no exception for extenuating circumstances.
The Mortgage Forgiveness Debt Relief 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.
Loan Modification
A loan modification is when the lender agrees to modify a part or all of the terms of the original mortgage loan agreement. This existing note is modified and remains in place. Changes to the agreement can include: extending the term of the loan, changing the monthly payments, and changing the interest rate to make the loan more affordable and to help the homeowner avoid foreclosure or bankruptcy.
Loan modifications have become extremely common. So much so that a backlog of cases has forced lenders to prioritize their caseloads. This largely means that many homeowners are being forced into default to get their attention. This is unfortunate, because one 30-day late pay can cause a 50-80 point drop in credit scores. The good news is that borrowers who choose this option vs. foreclosure or bankruptcy, show that they are exhausting every effort to pay the loan, and the effort will show in your credit scores and history.
How Does A Loan Modification Affect the Borrower’s Credit?
Lenders use special codes to report consumer account information to the credit bureaus. When the loan modification program was announced, lenders used an existing code, called AC, to signal that their clients were participating in a loan modification program. The problem for those borrowers, was the fact that the AC code indicates that the consumer has only made a partial payment, or has entered into a settlement agreement, paying less than the amount due. Why would lenders use this code? Because there is no code for a loan modification, and the AC code is the closest fit.
Here’s the good news, a new code was developed in November 2009. It is called a CN code, and it will indicate a loan modified under a federal government plan -- which should eventually have no impact on credit scores.
Here’s the temporary bad news -- for the time being, the FICO scoring model does not consider the new CN code. Before a change of this magnitude can be made to the FICO model, FICO must concludes that the code in a credit file is accurately predictive of the consumer's behavior. That means testing, case studies and research, which will hopefully be completed by year end.
Note: The new CN code will not eliminate late pays that were made during the loan modification process. So Borrowers who pay late will still see a significant drop to their credit scores. And, regarding consumers who have already been reported under the AC code, at the moment, there is no retroactive guidelines, however, most experts believe that there will be soon.
Bottom line, if you are a homeowner who is in the process of a loan modification now, or a homeowner who has already gone through the loan modification process, you should ask your lender to report the account under the CN code now, that way the new code takes affect, your scores should go up immediately.
Bankruptcy Mortgage Relief
Currently, bankruptcy offers very limited protection to a homeowner who is upside down with his or her 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, as of now, no bankruptcy proceeding can modify the terms of an existing home loan on a principal residence.
How Long Before You Can Buy Another Home After Bankruptcy?
The current guidelines from Fannie Mae & Freddie Mac state the waiting period for a Chapter 7 Bankruptcy is 4 years from either the dismissal or discharge date. The exception for extenuating circumstances is 2 years.
A distinction is made between Chapter 13 bankruptcies that were discharged and those that were dismissed. The waiting period for a Chapter 13 bankruptcy is:
- 2 years from the discharge date, or
- 4 years from the dismissal date.
There are no exceptions for extenuating circumstances.
In the case of multiple bankruptcies, the current guidelines state that the waiting period is 5 years from the most recent discharge or dismissal date. The exception for extenuating circumstances is 3 years from the most recent discharge or dismissal date.
WORD OF CAUTION: If you are facing a foreclosure, short sale or bankruptcy due to circumstances of losing a job, a medical crisis, the sub prime mortgage crisis fallout, it is suggested that you fully document your experience - starting now. It's not recommended to wait until later, because, if you decide to apply for a loan in two years based on an extenuating circumstance claim, the details and emotional energy of what you are going through will be more difficult to document and prove down the road.
There Is Good News!
- Aging Out: In all instances above where I reference how many points will be lost in each scenario, it is important to understand that over time all derogatory accounts age out. This means that the older the account, the less it will hurt your credit scores.
- 7-Year Reporting Period: The law states that derogatory items "can be" reported for 7-10 years. It doesn't state that they "MUST BE." There is no need to wait out the 7 years. You don't have to. You can start seeking early removal of the item by asking the credit bureaus that are reporting the information to send you a copy of the information they have on file to verify their reporting. Law states that they MUST have absolute verification, or remove it from your report.
- You can start recovering and rebuilding immediately. You do not have to wait to start recovering and rebuilding. Contact me for some great tips on how to get started now.
Which is The Best Choice to Protect Credit Scores?
Each of the scenarios presented in this report has a specific impact on credit scores, but it’s important that each individual understands that this is a very personal decision. A borrower must weigh the impact 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, in many instances they are in the grey as much as the consumer. So homeowners in trouble should not feel intimated by them.
In Conclusion
My advice to any homeowner 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 the pros and cons. What may seem to be the best answer right now may also have a serious impact for many years to come, so make an educated decision.
The great news is that whatever fate falls upon your credit scores right now, you can start improving your situation immediately.
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