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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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The sad reality is that loan modifications are not helping most troubled homeowners save their mortgages from foreclosure. Alternatives are needed. The government has seen this, and is putting all its leverage on servicers, junior lien holders, and lenders to fast track short sales.

However, many troubled homeowners are asking: Why Should I Even Try to Get a Short Sale? I am Going to  Lose my Home Whatever I Do? This is a fair question. Foreclosing on your mortgage does not require much time and effort, but short selling your house does. What are the benefits, if any, of applying for a short sale on your home?

This article will look at 3 benefits. None of these benefits will save your home, but they will make it much easier to cope with the aftermath of losing your house, and make it much easier to get on with your life.

Benefit 1. Buying a Home. It is much easier, and faster, to buy a home after a short sale than after a foreclosure. If you foreclose on your current mortgage you might be eligible for a loan after five years if your current mortgage is your primary home. If the home you foreclose on is your secondary home you will have to wait seven years. However if you short sale you could apply for a Fanny Mae mortgage immediately if you were not behind on your payments. If you were behind in your payments you will have to wait 2 years.

Benefit 2. Getting a Loan. Even if you are not planning to buy a home any time soon you will probably want to get a loan. A foreclosure will destroy your chances of getting a reasonable loan for up to 7 years. There is a question in every loan application that asks if you have foreclosed on a mortgage. If you lie you can be investigated for fraud, if you tell the truth you can kiss goodbye your loan.

Benefit 3. Your credit rating. Credit rating is not only important to get a mortgage or a general loan. It is also used by employers when selecting potential employees, and landlords when screening tenants. The bad news is that foreclosures destroy your credit rating. Credit rating ranges from 300 (dismal) to 850 (excellent). A foreclosure will drop your rating by anything from 200 to 400.

However, a short sale will either nudge your rating down by a 100, or not affect it at all, because many lenders do not even report short sales to credit bureaus. Add to these benefits the fact you could get a $3,000 incentive and you should be able to answer why it is better to apply for a short sale from your lender than simply sending him some jingle mail.

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Despite the Government’s best efforts and greatest intentions the wave of foreclosures continues to increase. The borrowers that are now defaulting on their mortgages and not qualifying for loan modifications are no longer people with subprime loans and bad credit rating. The fastest growing demographic in foreclosures are prime borrowers with prime loans that have lost their jobs and cannot afford any kind of deal on their mortgage.

This is a tragedy for the millions of families that face losing their homes. However there is a flip side to the crisis in the housing market. The flip side is that the foreclosure market is doing great. More and more buyers with cash in their pockets are looking for bargains among the millions of homes that are going through a foreclosure.

Many have the idea that the only homes that are on the foreclosure market are located in crime-ridden areas and are run down shacks. This is simply not true, during economic crisis like the one we are now going through all kinds of homes can be found, from beachfront luxury homes to shacks in the ghetto.

There is another myth a serious buyer must forget about as soon as possible. You are not going to find a great property selling at pennies on the dollar. Sometimes you can find amazing deals but this is probably because there are other circumstances that reduce the value of the home besides being on the foreclosure market.

However, you can get some great deals and discounts. A typical discount is probably around 5% less than the market value, although you can sometimes pay up to 30% or 40% less.

If you are savvy enough, this could only be the beginning of your savings. If you buy the property from the lender you could ask/demand for some of the buying costs to be waivered. If you ask nicely you might even get a discount on the interest rate or a break on the down payment.

Buying a home, whether on the foreclosure market or not, is a huge investment for most of us. It is therefore worth us spending some time doing our research and due diligence before we spend tens or even hundreds of thousands of dollars.

The foreclosure ball begins to roll when a borrowers falls behind on mortgage payments. A homeowner that loves his home will try his best to keep his home, making some payments, looking for a loan modification, or any other measure he can. However, if the home still forecloses the chances are that maintenance has not been carried out for some time on the home. Include the costs of bring maintenance up-to-date in your investment research.

What this might include will depend on the property. Some just need some gentle manicuring, while others have underlying structural damage that is prohibitively expensive to fix. It is true that homes in need of some tender lover and care will come at a discount, but it is important to make sure you can afford the cost of providing it.

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The sad truth is that most troubled homeowners do not qualify for a trial loan modification. Of these, only a small percentage will receive a permanent modification. Analysts estimate that over 5 million households have underwater mortgages and are struggling with their payments. This represents nearly 20% of all American households. Many of these homeowners are going to lose their houses. The question is how soon can borrowers that foreclose on their homes buy a new home. The answer depends on the type of foreclosure and the extenuating circumstances of your particular case.

Who decides how soon you can get a new home loan?

The answer is the lender and their insurer. Although there is not one central body that sets fixed rules on this issue, there are clear guidelines set by Fannie Mae. Fannie Mae is America’s largest mortgage buyer. You might not even know that Fannie owns your mortgage because “she” does this on the secondary mortgage market. Because this corporation buys such a large percentage of mortgages, lenders will often follow in line with its guidelines.

What are the guidelines?

They can be found in Fannie Mae’s website and documentation. Below I detail the current guidelines, but these can change quite regularly so I encourage you to see them as a ballpark figure and then check for yourself.

How long you must wait after a foreclosure?

The quick answer is 5 to 7 years. However if there are extenuating circumstances the waiting period can be reduced from 3 to 7 years.

What about when you carry out a Deed-in-Lieu of Foreclosure?

It is actually worse; you should expect to wait between 4 to 7 years. However, if there are extenuating circumstances this might be a good option for troubled borrowers that want to buy a new home quickly, as the waiting time is reduced from 2 to 7 years.

What about short sales?

The current waiting period is two years. However, and this is an important point, if you are current on your monthly payments you can purchase a new home immediately. This is a powerful reason to stay up-to-date with your payments if you possibly can.

What are extenuating circumstances?

This refers to the reasons (or excuses) you provide to explain why you cannot pay your mortgage. There are many extenuating circumstances but your bank is only going to accept those you can prove, with documentation, are beyond your control and fall within their list of acceptable extenuating circumstances.

Fannie May will consider death (of a close relative, or partner), illness, job transfer, serious injuries from an accident, and other mitigating factors that dramatically affect your ability to pay your loan and are outside of your control. Unfortunately not being able to afford your payments because the interest rate on your variable interest loan has increased is not considered a mitigating circumstance.

These guidelines can help you make better decisions when trying to find the best choice when foreclosing on your home. Make sure you can prove the financial hardship you are going through and try to work with your lender with an option that will give the best chances of getting a clean start as soon as possible.

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Recent projections estimate that by June, over 5 million homeowners will be heavily underwater. Let us define that a little more precisely. You are heavily underwater if the current market value of your home is only 75% of the balance on your mortgage. Between you and me, this means you are pretty screwed. The scary part is that if this projection proves true 10% of all US homeowners will be in this pickle; not the place you want an economy to be if you are trying to dig yourself out of a recession.

This is why the Obama Administration is running about like headless chickens trying to find solutions to this problem, quick, mid-term, and long term solutions; any kind of solution that will get us out of this.

It was this kind of panic that caused the government to put all their weight behind HAMP, the government’s loan modification program. Loan modifications were and always have been procedures designed to help homeowners stuck with sub-premium loans. Sub-premium loans as you all know is a kind way of talking of usury, loans with interest rates so high they give you vertigo if just to think about them. However loan modifications are not, and never have been a fix for homeowners with great loans that are unemployed and cannot afford their mortgage.

What alternative solutions are there?

One proposal is to buy time by simply banning foreclosures until other options have been looked into by the homeowner and lender. You have to love that proposal, if you cannot stop homes foreclosing by economics just make it illegal. As crazy as this measure seems it is designed to buy time and allow homeowners to find ways of keeping their home. This would take the current guideline of asking lenders to evaluate defaulting homeowners for a loan modification to the next level by making it compulsory.

The Mortgage Bankers Association says its members are already following this principle, and that foreclosure is always a last resort when all other options have been exhausted.

Another plan sponsored by the Mortgage Bankers Association is to not modify permanently the loans of troubled homeowners that have lost their jobs but simply to reduce their mortgage payments substantially for up to nine months to give homeowners a chance of looking for a new job.

As you probably guessed the Banker’s Association is requesting Treasury to pay for the program. Nevertheless, it does seem like a good idea to provide a homeowners with a break until he finds a new job than taking forever to marginally reduce the mortgage payments of an unemployed borrower.

However, many are analysts are saying that the real strategy to follow is to find a way to improve the economy. A strong job market would pull out the housing market from the fix it is in. On this theme, there were some good news last week. The number of homeowners starting to default unexpectedly dropped in the fourth quarter of 2009. However, the government also reported that home prices dropped by 1.6% in December; making it clear that the economy still has a long way to go before it gets a clean bill of health.

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If you do not qualify for a loan modification, and foreclosure seems unavoidable, there are steps you can take to make the most of a bad situation. One of these options is arranging with your lender for a Deed in Lieu of Foreclosure.

What does this mean?

It means you hand over the deed, or ownership, of your house to the lender in exchange of clearing your debt. The homeowner loses his home but is left without a debt while the lender takes immediate control of the house.

What advantages does this option have?

In certain circumstances a Deed in Lieu of Foreclosure can have significant advantages for both the lender and the buyer.

1)     The lender can take immediate control over the property. A much more efficient method than foreclosure proceedings that can take years to finish.

2)     The borrower foregoes his home but is left without any debt.

3)     Lenders can save themselves a lot of money in court expenses, time and other complications if they avoid a typical repossession procedure.

4)     Borrowers that avoid a foreclosure will remove the stain on their record and in some cases avoid bankruptcy.

What are the requirements for a Deed in Lieu of Foreclosure to be carried out?

1) The market value of the home must be less than the current balance of the mortgage.

2) There must be no third party credits secured by the home, like a second mortgage or a secured car loan.

Although it might seem counterintuitive for a homeowner to let his home, probably his largest investment, go without anything to show for it, it can be a much better alternative than a long and painful foreclosure. Borrowers don’t have to see their credit score hurt and can start again elsewhere, while lenders can cut their losses and try to make the most of a bad loan without having to continue spending money and resources.

In what circumstances should a homeowner think about handing a Deed in Lieu of Foreclosure?

Obviously, homeowners that are going through financial difficulties and cannot afford their monthly mortgage payments. However if they still have some sort of income then they may well qualify for a home modification or some other option. This path is more suited for homeowners that either cannot afford any kind of loan modification or feel that their home is too underwater, worth less than the mortgage balance, to be worth saving.

How is it done?

Both parties must agree to sign an Agreement in Lieu of Foreclosure. This document transfers ownership to the lender. In some cases the homeowner might pay a certain amount of money to reduce the loan and make sure her credit score is not affected. Once the document is signed the lender will issue a waiver to deficiency judgment, which will be used if the sale of the house is below the value of the mortgage. After this an escrow service executes the agreement; releasing both the lender and the borrower from their mortgage contract.

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Although there are many steps a homeowner can take to avoid losing their home and qualify for a loan modification, loan refinance or other financial rescue procedure, the sad reality is that many homeowners will lose their home. If you are struggling with your payments and trying to get a loan modification you need to accept the possibility that you may lose your home.

The question is what will you do?

Would you declare bankruptcy or simply foreclose on your mortgage?

This is a very complex question. This chapter will try to provide practical information to help you make an educated decision but the best advice is to contact a bankruptcy attorney that can guide you through the minefields of bankruptcy law and help you make a good decision based on your specific circumstances. Now we have that disclaimer behind us, let us have a closer look at our options.

When trying to work out which is the lesser of two evils, foreclosure or bankruptcy, it is worth comparing the pros and cons of each choice.

1)      A foreclosure will remain on your credit report for 7 years while a bankruptcy will stick to your report for 10 years.

2)      Lenders will view more seriously someone that forecloses on their home than a borrower that declares bankruptcy that doesn’t include a home. Generally a foreclosure leaves a bigger and longer lasting stain on your credit report.

Bankruptcy is an ugly book with many chapters.

Declaring bankruptcy is not easy, there are different ways to file for bankruptcy and you don’t even have to include all your debts. For instance, if you are still paying for your car you will probably want to continue paying for it so you are not without transport.

Bankruptcy in the United States is controlled by federal laws and handled by federal courts, although local state laws also come into play.  The two mast common types of personal bankruptcy are Chapter 7 and 13. If you file under Chapter 7, you are allowed to keep some of your assets. Which assets you are allowed to keep will depend on your State’s specific laws. The rest of your assets are turned over to a court appointed trustee that liquidizes them to pay your lenders. This is one of the many reasons it is a good idea to hire a good bankruptcy lawyer, you need to understand your local laws on bankruptcy in order to make a good decision. Unfortunately, as with physical death, dying financially actually costs you money; you need to pay to be broke.

If you file under Chapter 13 you pay all your debts under a plan designed by the court. A court appointed trustee will collect your payments, satisfy lenders and make sure you stick to the plan.

If you are a business owner there is another option you want to consider carefully, and that is filing bankruptcy under Chapter 11. One of the advantages is that you can get to keep your business as long as the court and your lenders agree to a plan to payback your debts. However, if the court decides you need a trustee to check on you; you will effectively lose control of your business and its assets.

As you can see choosing what to do when you are losing your home is like deciding which limb you would like to lose –very difficult.

Other Options to Consider

As well as foreclosure and bankruptcy there are other options worth considering that might be softer on your credit score and overall stress. These require you talking with your lender and negotiating a faster and cheaper way out for both of you.

You can try a “deed in lieu of foreclosure” this arrangement involves handing over your home to the lender and walk away without owing, or owning, anything.

If your home is underwater, or worth less than the value of the mortgage, you can always try to negotiate a short sale with your lender. This means selling the house at a loss. Depending on your lender and the State you live in you might still owe your lender the difference. Even if you don’t owe your lender anything after a short sale you might still owe the Government in taxes, as unpaid loans are often considered by the IRS as declarable income.

A final option is to ask your lender to hold off from a foreclosure while you try to sell your home. This is a great option if your house is not underwater and you can at least pay for your mortgage from the proceedings of the sale.

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The debate in the last months has centered on how the Government and lenders were not doing enough to get troubled borrowers into a loan modification. However, a recent report might indicate that this has actually a good thing for borrowers!

A report released last week by the State Foreclosure Prevention Working Group disclosed that about 72 percent of the loan modifications carried out in October ended up owing more. This is because lenders will add missed mortgage payments with interest to the modified loan. Therefore, although loan modifications may reduce monthly payments they sink borrowers further into debt.

This does seem an oxymoron, to help troubled borrowers by increasing the size of their loan. Supporters of the scheme say that this is necessary evil for lenders to be able to afford the modifications and allow borrowers to afford their mortgage payments and keep their homes.  But is this even true?

Reports show that the number of borrower that foreclose after completing a mortgage modification is much higher when their mortgage balance was increased or left unchanged. This is because borrowers have little incentive in staying with a house that is worth less than their mortgage. If this is the case they will often simply walk away from their mortgage with means considerable costs for lenders.

This is called the underwater effect. Borrowers that own homes that are worth less than their mortgages have little hope to regain equity and are seen by their owners as a liability instead of an investment. Studies show that the best way to reduce foreclosure rates, a nuisance for both borrower and lenders is to reduce, even if only a little, the principal balance of the loan.

But is it the government’s job to force lenders reduce the principal of loans?

This is of course the big debate. On one side you will have those that feel most borrowers had it coming. “I knew I couldn’t afford it, so I kept on renting. Why should they get bailed out for borrowing irresponsibly?” seems to be a common opinion. The logic of the argument is hard to fault.

On the other hand there is the moral argument that the Government has a responsibility towards troubled families that could end on the street, which from a pragmatic point of view might even cost society more in handouts.

The other question is why even try and stop foreclosures? Many view them as a natural outcome of a financial crisis and that the market will normalize itself after going through the “normal” post crisis period.

Many feel that the best move underwater borrowers can make is to simply walk away from their mortgages. When asked about the morality of breaking the mortgage contract most will say banks had it coming when they started lending irresponsibly.

If your mortgage is underwater this is a good question to ask yourself. Is it really worth it for you to stay with your mortgage? Or would it make more sense to simply walk away, take the hit on your credit score and carry on with your life? The answer will depend on how much you have invested in your home, financially and emotionally.

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The problem with loan modifications is re-defaulting. Well, that is only one of many problems with loan modifications but it is certainly one of the most annoying ones for lenders and the Obama administration. This is because loan modifications cost money. They cost money, they take time and this is a complete waste if the borrower re-defaults shortly after completing a loan modification.

That is why the government is interested in finding out what kind of loan modifications are less likely to re-default. The Federal Reserve Bank of New York carried out a new study that analyzed the success rate and re-default rates of different loan modifications.

The study reveals that when loan modifications reduce the principal, or write down loan balances re-default rates drop by half.

Loan modifications come in a variety of shapes and flavors. The main purpose of loan modifications is to reduce the monthly payments so that borrowers can afford them. Not surprisingly the most successful loan modifications are those that reduce loan modifications by the most. However there is more than one way to skin a cat and the same goes for loan modifications. Monthly payments can be reduced by reducing the interest rate, lengthening the term or rolling the interest to the end of the loan and of course the bank can write off part of the loan.

The above mentioned report showed that how the monthly payments were reduced affected re-defaulting rates. For example the findings showed that when a modification reduced the borrower’s interest rate by 2.8 percent and reduced monthly payments by 25% probability of re-default is reduced by 11%.

However when loan modifications reduced monthly payments by the same 25% by reducing the loan balance and through a slight interest rate reduction re-defaults drop by 26.5%.

This could have important implications for the government in its efforts to help troubled borrowers from losing their homes. The government is willing to invest money in incentives and programs to support loan modifications if this report is correct the money might be best spent for all involved reducing loan balances than lining lenders’ pockets.

Why does reducing loan balances reduce re-default rates?

The answer seems to be that many borrowers re-default on their loan modifications because their homes are so underwater there is little incentive in throwing good money after bad towards a mortgage that is worth more than the house it is paying.

However when lenders reduce the balance of a loan this increases the prospect that house price appreciation might bring the borrower out from underwater and back into positive equity. This provides extra incentive to the borrower that sees financial benefits in continuing to pay the mortgage despite it being underwater. If this study proves to be true it might be profitable for lenders to write off portions of a loan as part of a loan modification while maintaining interest rates or only reducing them slightly.

Both reducing interest rates and reducing the loan principal costs lenders money the important question is which option is most cost effective in the long run.

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The Obama administration and all the agencies at its disposal are working around the clock to save troubled loans but it is simply not good or fast enough.

In the third quarter there was a 6.2% rise of all seriously delinquent (i.e. 60 days or more past due) and 3.2% increase of all loans in the process of foreclosure.

What is even scarier is that even prime mortgages, those loans with the best interest rates and conditions also rose heavily.

However banks and loan servicers do seem to have stepped on the gas a little and supported the government’s efforts through the HAMP program, or Home Affordable Modification Program. Out of every 6 troubled homeowner one received a permanent or trial loan modification. Unfortunately the homeowners that get a trial but don’t get a permanent modification make up most of that figure. The bad news is that even those who do get a permanent loan modification (31,000 out of 750,000 in the last count) half tend to re-default with 6 months. The good news is that that loan mods done in the second quarter show a lower initial re-default rate. This could be because lenders are making more generous loan modification and reducing monthly payments more aggressively to make payments more likely.

So how are mortgages performing? Badly seems to be the sad consensus. 87 percent of all US home loans are listed as performing, which obviously means 13% aren’t. Government backed mortgages are not faring much better, in some cases worse. Only 83% of the Veterans Benefits Administration loans are “performing”. Fannie and Freddie mortgages (with government backing) are not celebrating with 8% of their mortgages “not performing.

It is not all bad news. The housing market with low interest rates and a large portfolio of “cheap” homes is attracting buyers. This large inventory is likely to stay with us for a while as banks continue to try to unload their distressed properties and troubled homeowners continue to agree to “short sales”.

According to First American CoreLogic one in four home loans is still “under water” or has a mortgage that is worth more than its current value.

What is the government doing to fight this situation?

Two main strategies: 1) Keep the housing market stable by keeping the interest rates low.

2) Loan Modifications.

The first strategy does seem to be helping by encouraging buyers to invest in a new home. Loan modifications are not meeting with the expectations but the latest figures do show that re-defaulting has dropped with the latest more generous mods.

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