Credit score


Over the past few years as home values have taken a nose dive, we’ve witnessed a new group of borrowers in the default arena – enter the strategic defaulter.  A strategic default occurs when a borrower who is financially able to make their monthly mortgage payment, chooses to walk away from their property because they owe more than the home is currently worth.  The rationale is that it doesn’t make financial sense to continue to pay for negative equity, waiting and hoping that the home’s value will increase and they will re-coup their lost equity.

To banks that are already struggling to cope with the thousands of borrowers who are legitimately unable to make their mortgage payments, this group represents a growing challenge.  According to studies by the Chicago Booth School of Business, strategic defaults in September 2010 represented 35% of all defaults, up from 26% in March 2009.  Last year the problem became so large that Fannie Mae announced that it would seek stringent penalties against borrowers who are able to pay, but choose to walk away.

Hoping to stem the tide of strategic default, banks are looking for ways to identify those borrowers most likely to walk away from their mortgage obligations.  The problem however, is that to date there has been no reliable way to identify the potential strategic defaulter.  Intervention is impossible if you don’t know who you’re looking for.

FICO Research Labs may have developed the tool banks are lacking.  The credit assessment company announced that it has developed a method that analyzes consumer spending and payment habits and allows lenders to identify borrowers who are 100 times more likely to default than others.  

So what is the profile of the strategic defaulter?  They are actually quite savvy managers of their credit having higher FICO scores, lower balances on revolving debt, less retail credit usage, and fewer instances of exceeding credit limits than the general population.  FICO claims the company’s new analytics can provide loan servicers with a method of reaching two-thirds of these would-be strategic defaulters, and according to Dr. Andrew Jennings, head of FICO Labs, “The ability to spot likely strategic defaulters before delinquency enables servicers to intervene early.”

But then what?  It is one thing to identify borrowers who might choose strategic default, but, what intervention can banks offer that will actually deter would-be defaulters? If lenders follow Fannie Mae’s example and simply threaten legal action to recoup outstanding mortgage debts, I doubt that will be much of a deterrent or solve any of the real problems.

The issue comes back to a point I’ve often made in this blog:  I don’t believe we are going to see a significant reduction in defaults, both strategic and involuntary until lenders are ready to consider meaningful principal reductions for borrowers who owe more than their homes are worth.   If Savvy Bob the Homeowner is considering default because he owes $80,000 more than the home is worth, do you think he might consider staying in his home if his principal balance was reduced by $60,000?  Throw-in a lower interest rate and I’m pretty sure you’d have a deal.  Considering the bottom line expenses for banks to foreclose, costs for carrying an REO, lost revenue, and a lower net sales price, principal reduction should start to look pretty good.

So I’m all for identifying those who are likely to choose to walk away, but before banks rush to hit them over the head with penalties, l hope they’ll put some thought into resolving the equity issues that are driving strategic default and offer borrowers a meaningful alternative.

Short sales can be a real pain for everyone involved…sellers, Realtors, buyers…and because so many fail, people are often left with a negative view of the short sale process.  But, do you really know the benefits that might make it worth the effort?

As I’ve mentioned before, I work with an exceptional short sale negotiation company that has a 99% success rate in getting approvals.  The president of that company recently put together a nice chart outlining the benefits of a short sale vs. a foreclosure and I’ll share the highlights.

Future Ability to Purchase a Home:    When you apply for a home loan, there is a question on the application that asks, “Have you had a property foreclosed upon or given title or deed-in-lieu thereof in the last 7 years?”  A positive response may impact your ability to qualify and will certainly influence the interest rate you are charged.  Currently, there is no question on the loan application with regard to short sales.

Impact on Credit Score:    With a foreclosure, credit scores can drop 250 – 300 points.  Conversely, with a short sale only late payments will impact the credit score.  After a short sale, the mortgage that was paid-off short will be reported as ‘paid as agreed’, ‘negotiated’, or ‘settled for less than agreed’.  This can lower your score as little as 50 points and will usually have little to no effect in twelve to eighteen months.

Impact on Credit History:   Foreclosure remains on your credit history for seven years.  Since short sales are not specifically reported their impact is only as great as the number of missed payments, as noted above.

Deficiency Judgment:  Unless you’re in a state with anti-deficiency laws, the bank can pursue a deficiency judgment.  In a successful short sale, the bank will waive the right to pursue a deficiency judgment.

Current and Future Employment and Security Clearance:   Many employers require credit checks for all employees, and certainly for anyone hoping to attain a security clearance.  While individual companies and agencies have different requirements, a foreclosure can have a negative impact on your ability to get a job, keep your job, or get certain clearances.

Of course I’m not a lawyer or accountant, and each individual’s situation is different, and not everyone will qualify for a short sale.  You should always consult the appropriate professional for advice.  But as a real estate professional, I would definitely give the short sale serious consideration before deciding to just walk away.  For a confidential consultation just give me a call at 619-846-9249.

The most frequently asked question about selling your home through a short sale is “What will this do to my credit?”  Like most questions in today’s real estate market, there is no single answer.  But the good news is that you may be able to buy another home much sooner than you think.

There are many factors that determine the all-mighty credit scores, but generally a short sale will cause your score to drop by 100 – 200 points.  This is true if your short sale is reported as “settled for less than agreed”, and no deficiency judgment is filed.  This is a critical point, and it is important that you and your Realtor carefully read the language used in any short sale approval.   In California, SB 931 goes into effect on January 1, 2011 which protects borrowers from lender recourse on a 1st  mortgage, but may still leave them vulnerable on 2nd mortgages.  If you are unclear about whether or not your lender can file a judgment or if they ask you to sign a promissory note, consult with an attorney before signing anything!  A deficiency judgment or other recourse will increase the long-term negative impact of the short sale on your credit.

Another important factor is the length of time of default before the sale and whether or not a Notice of Default (NOD) was ever filed.  For many lenders, the filing of a Notice of Default is nearly as derogatory as an actual foreclosure.  A foreclosure stays on your report for 7 years and with either a foreclosure or NOD, you will most likely not be able to buy another home for a full 3 -5 years.  However, with a short sale that did not include an NOD, you may be able to qualify in as little as 2 years, according to some lenders.  This is another reason why it is important to act quickly once you realize you can no longer make your mortgage payments.

The most important factor is improving your score after a short sale is how you manage the rest of your credit.  I have several clients who just 18 months after a short sale have brought their credit back up over 700!  A few of their tips include:

  • Don’t take on additional debt
  • Stay ruthlessly current on every payment
  • Gradually pay down balances to a level that is 1/3 of your total credit line, but don’t close accounts.  Better to pay them off, and use them occasionally.

As short sales become more and more common on credit reports their impact on your non-mortgage credit will likely lessen, and even if you once again choose to buy a home, you may be eligible in as little as 2 years.