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There has been a lot of ink spilled on the issue of loan modifications, foreclosure, short sales, and their effect on your credit score. Depending on which newspaper, blog, or Wikipedia article you read there are a couple dozen theories or authoritative statements on how the whole credit scoring system works.
If you are planning to do any of the above: modify your mortgage, foreclose on your mortgage, short sale your home, or any other loan related activity it is worth finding out what the effects will be on your credit score. But why is our credit score so important? And, how does your payment history affect it?
Your credit score is important because it summarizes your credit risk to lenders and businesses. It is a number that describes your financial reliability as a borrower. Some employers and landlords also use this score as one of many ways to get a background check on us. If we apply for a loan and our credit score is low we a) might not get approved, or b) will have to pay higher interest rates than if we he had a higher score. It is as simple as that.
What makes up your credit score?
The biggest factor is your payment history. Around 35% of your score is based on your borrowing and paying record. This is quite understandable; a lender is justified in wanting to know if you have paid your debts in the past. This does not mean that a single (or event two) late payment/s will automatically destroy your credit score. An overall good record of paying your loans could outweigh a couple of bad instances.
This doesn’t mean either that if you have no late payments you will have a perfect score (that would be 850, in FICO’s main scoring system), there are many other factors to consider.
How long will past delinquencies affect your credit score for?
Bankruptcies, foreclosures, wage attachments, and other cases of delinquency seriously affect your credit score. How recent and frequent a case of delinquency is also counts in your credit score. Bankruptcies will stay on your credit report for 7 to 10 years depending on what chapter you filed under. The good thing is that more recent activity in your account will weigh more in your credit score than older delinquencies. A foreclosure, even though some of our readers would like to believe otherwise, will stay on your credit report for a long time. How long is not specified by FICO, but even a 90 day late payment 5 years ago will affect your credit score. Although thankfully the longer ago a delinquency occurred the less effect it has on your score, which means it is worth trying to improve your score because what you do now will have a great effect on your score.
Note: A great reference to learn the basics of the wonderful world of credit rating is ”Understand your FICO Score” booklet provided by FICO at http://www.myfico.com/Downloads/Files/myFICO_UYFS_Booklet.pdf. FICO credit scores are the most used credit risk scores in the United Sates.
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Do loan modifications affect your credit score? Should they? Why should you care?
Credit scores are a numerical value credit bureaus place on a borrower as a way of measuring their reliability. It is in the interest of lenders to report any delinquent activity to the credit bureau. In fact some would argue that it is in the interest of everyone as delinquent borrowers make loans more expensive for everyone by forcing lenders to increase interest rates to pay for bad loans. This is why potential borrowers that have bad or low credit scores find it harder to get loans approved or have to pay a premium for the privilege.
Borrowers that don’t make one or various payments are marked by a special code that informs other lenders of the situation. Borrowers that are granted a reduction of their loan balance or monthly payments due to financial difficulties are also marked with a special code called AC. This code can reduce the credit score of a borrower by anything between 30 and 100 points and tells lenders that the borrower had only made a partial payment.
The problem arose when troubled borrowers entered the loan modifications sponsored by the government and were granted loan modifications without ever having missed a payment but were still marked with AC as it was the closest fit in the “system”.
The Obama Administration felt it was unfair to harm the credit scores of borrowers that sought a loan modification. Therefore a new code “CN” was thought up which will not have an impact on credit scores for now.
The question is if this will change. Will the code CN affect the credit score of borrowers in the future? This is still to be determined. It will depend on if FICO, the company behind the most popular credit score formulas, decides the appearance of CN in a credit report increases the chances or is predictive of delinquent behavior.
It is worth noting that borrowers that enter into a loan modification are asking for a reduction of their loan and are therefore not wonderful news for lenders that are looking for reliable customers. It is not at all clear to me why it is wrong that their credit score is somewhat affected.
However what is certain, and this is what worries the Administration is that borrowers with a good credit history will shy away from a loan modification that threatens their credit. Lenders might argue that borrowers who feel they have a choice and prefer not to enter into a loan modification that would damage their credit don’t really need it and can very well pay the full loan, thank you very much.
How you feel about the matter may very well depend on which side of the fence you are looking from. The Obama Administration wants to give HAMP the best chance possible and is eager to erase any bad publicity the program attracts even if this means fudging credit reporting codes. Whether these measures are long lasting or not will depend on the performance of borrowers that enter into a loan modification, it must be said at this stage that things don’t look all that good.
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One of the greatest culprits for serious debt problems are credit cards. Obviously it is our bad use or management of credit cards that causes the debt problems, you can’t blame a gun for what its owner does with it. Nevertheless some guns are more trigger sensitive than others, and it’s not the same to own an automatic machine gun than an air gun. It’s all about understanding the rules of the game and what the real cost of your credit is. The Obama administration have backed the implementation of new credit card rules that will help many of us to save money and stop paying so much of it to the banks in fees and penalties.
What are the new rules?
Raise interest rates on existing balance. This is a great victory for consumers. This is a little known tool banks had in their arsenal of money making methods. In fact most of us probably didn’t know the bank could increase the rate of interest on our credit card without asking. If you think of it that is pretty crazy because the interest rates on credit cards are already huge.
Payments will pay off your most expensive debts first. Borrowers using credit cards, especially when transferring balance from one card to another, can find themselves with different rates of interest for debts on the same card. Previously there was not guideline or rule on which part of the debt banks must use your monthly payments to cover. Obviously banks had an incentive to pay the cheaper interest rates first and leave the most expensive rates to last. With this new credit card rule that will not be a legal course of action for banks that must allow borrowers to pay off their most expensive credit card debt first.
Other cards can’t penalize you for missing a deadline on another cards. We all know that banks are a closed knit community. They might compete against each other but when they are dealing with borrowers data, credit record and payment history they are happy to share their knowledge. They can still share information on delinquent credit card payers but can’t hold it against them.
None of these measures will stop the banking industry from making more and more money on our misuse of credit cards but it has plugged some holes banks will no longer abuse.
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Desperate situations elicit desperate measures. Many families are certainly living in desperate situations due to the current worldwide economic crisis with millions of families losing their homes in the U.S alone. These families and households are reaching levels of desperation where any option that provides an ounce of hope or even a temporary respite is considered. What options do they have?
Although there are various viable options open to borrowers in financial difficulties there are also some terrible options open for people that don´t understand the consequences of some of the ”solutions” borrowers provide. An inspiring story that hit the news this week was that of a recently divorced lady that was about to foreclose on her mortgage. Instead of accepting the charity of friends she sold double decker apple pies to friends and neighbors. The story touched many around her world and her business went international in the process saving her from losing her home.
Not all of us can imitate such feats of entrepreneurship but we can all make steps to increase our income and reduce our at least manage our debt. The first financial crouch borrowers seem to grasp for are credit cards. Credit cards are handy financial products that provide quick cash when needed; they are not a useful way of finding money to pay for loans. Paying loans with credit cards is like selling your car to by fuel, not very clever. To illustrate this just have a look at the interest rates credit cards charge, anything between 11% and 19%, even more in some countries and compare it to interest rate of a personal loan, car loan and a mortgage. It is much better to modify or renegotiate your current mortgage, take on a personal loan or even negotiate with you lenders than fall into the slippery slope of credit card debt. Another bad choice is to do nothing when you find you are not going to be able to pay your mortgage or loan payments.
It is vital to talk to your lender and find a solution you both can live with. Many banks and lenders will provide a number of breaks or solutions to borrowers that come out in the open when struggling to meet mortgage or loan payments. For instance if you are waiting for a large sum of money or are expecting a rise in income (that you can prove) lenders are often willing to provide a “payment holiday” for a set amount of time to help you get on your feet. Doing this instead of sticking your head in the ground and just letting things happen also has the benefit of not affecting your credit record which will be destroyed if you simply stop paying your loans. If you are unsure on how to deal with your debt problems be smart and talk to someone that can help you. This website describes some of the steps you can take to alleviate the stress and problems caused by debt and bad management. The choices you make will decide your financial future.
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So you are in serious debt. Really serious debt. You are actually quite desperate because you have no idea how you got in such a pickle and even less of an idea how you are going to get out. Debt management is your newest best friend. What is debt management and how can it help you to get out of debt?
Debt management is the art of taking control of your debt and using the tools at your disposal to minimize the cost and damage of debt. Debt management is not a single solution like a magic pill or a silver bullet, it is more like a way of thinking, an attitude that helps you make the right decisions to get yourself out of serious debt.
Debt management affects our lifestyle, our spending habits and our financial decisions. The principles behind Debt Management are simple: Understand your debt, minimize your debt and control your debt.
This is how it works:
Understand your debt.
You need to know how bad your situation is before you can fix it. Many people develop such a phobia to their debt, they try to ignore it ostrich style, and this obviously creates problems of its own burying the person deeper into debt. So get paper and pen and write out exactly what you owe, that includes your mortgage, credit cards, car loans, everything and include the interest rates you are paying on them.
Minimize your debt.
The second step after understanding your debt is to start to managing your debt by taking decisive action. Your first priority is to work out what your income is and compare it to your monthly expenses. This is where debt management gets really hard. Often people who are in serious debt have got used to spending more than they have and reducing their quality of life or spending habits seems impossible. However you will have to be hard on yourself, get your income and work out a budget that will fit into it. Working out a budget is a living project you will never finish, in you might have to re-design your budget after step 3, the important thing is to realize your limits and stick within them.
Minimize your debt.
There are different ways of minimizing your debt, lets have a look at two.
Debt management tools that will help your minimize your debt include debt consolidation and creating extra income to pay your debt.
Debt consolidation refers to taking on a large loan to pay for a bunch of smaller loans. This can be beneficial because one large loan can mean cheaper monthly payments and a lower interest rate.
You can also try to create some extra cash to pay your mortgage from assets, selling things you no longer need or can do without, redeeming of shares and insurance policies. It is often worth cashing in on an investment that is growing slower than your debt, once your debt is under control you can start to save again.
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A study by the Boston Fed has found that the administration’s mortgage rescue plan has failed to provide that all important profit incentive. According to today’s Boston Globe:
The Boston Fed’s findings suggest the Obama administration’s major effort to solve the foreclosure crisis by giving the lending industry $75 billion to rewrite delinquent loans to more affordable levels is not likely to work.
One of the study’s coauthors, Boston Fed senior economist Paul S. Willen, said the government would be better off giving the money directly to struggling borrowers to help them with their payments, rather than to lenders that are averse to working out the troubled loans.
“Loan modification is not profitable for lenders,” Willen said. “If it were profitable, they would go out and hire staff.”
Hard to argue with that logic.
Writing at the WSJ, Stan Liebowitz makes a strong case for the idea that now is exactly not the time for the government to be stepping in and fiddling with the markets.
The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising.
(Hat tip to the HousingDoom blog)
Leibowitz is hardly a laissez faire type. He just thinks that the economy would be best served by having government do what it should have been doing all along: Requiring, monitoring and enforcing strong underwriter standards.
We are at a crossroads where we can undo the damage to the housing market by strengthening underwriting standards in a reasonable way. But to do so political leaders must face up to the actual causes of the mortgage crisis, not fictitious causes that fit political agendas and election strategies.
Yeah, I’m not holding my breath on that one.
Constantine von Hoffman is a veteran business journalist and social media consultant. He write the blog CollateralDamage, a satirical look at marketing and business.
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