Q. What happens to your credit if you default on your mortgage?
A. A person who defaults on their mortgage payments is faced with 3 basic options: 1) do a short sale 2) let the property go to foreclosure 3) send the lender the keys and walk away.
Short of being able to make one's mortgage payments a "short sale" is the next best alternative. It's sort of a win/win/win all the way around. The seller's credit report shows that the creditor agreed to settle the debt owed them for less than the outstanding balance and the borrower's credit score takes a minor hit but is not trashed, the mortgage lender takes a loss on what is owed but probably 20% less than if it were necessary to foreclose on the property and the new buyer gets a property at a price that may be 10-20% below market.
The down side here is that the process can be protracted, lasting several months. The major hitch, usually, is that the lender (because they're taking less than what is owed on the property) has to approve the short sale, not the seller. Despite having a signed purchase and sales agreement one-third of these transactions fail to complete because, on average it takes lenders 4.5 weeks to provide an answer on a potential short sale, resulting in many potential buyers walking away. Lender's Loss Mitigation Departments are notoriously slow because they are geared for foreclosures, not short sales. Other common reasons for failed transactions are tied to problems with home inspections or damage to the property, seller refusal to sign a deficiency note, and the seller*s inability to pay a real estate commission or closing costs.
Still, in an imperfect world, a short sale is the best of all possible bad outcomes. Also, federal legislation enacted last year allows homeowners who negotiate loan modifications with lenders and have portions of their principal debt eliminated to escape income tax liability for the amount forgiven.
A much less appealing situation is one where the property is foreclosed upon.
Here, the seller's credit is going to be adversely impacted as though he had gone through a bankruptcy proceeding. Fannie Mae & Freddie Mac count foreclosures as major credit blots for seven years,
On March 31, Fannie Mae sent out new guidelines to lenders intended for foreclosure situations. Fannie will now prohibit foreclosed borrowers from getting another mortgage through the giant investor for five years, unless there are "documented extenuating circumstances." In those cases, the mortgage prohibition is for three years. Even after five years, borrowers with foreclosures in their files will be required to make at least a 10 percent down payment, and will need minimum FICO credit scores of 680.
The impact of a foreclosure on an individual's score depends heavily on the payment history, length and number of credit trade lines in a consumer's file, but it is always significant. Many borrowers facing foreclosure today have endured serious financial crises' loss of employment, loss of an income-earning spouse, medical issues, or predatory loan terms which led to their inability to make their mortgage payments. When they apply for a loan from either Freddie Mac or Fannie Mae, the standard application form asks whether they have ever experienced a foreclosure or handed over their deed in lieu of foreclosure. If applicants check "yes," the loan is immediately shifted to manual underwriting. Every piece of information is scrutinized by underwriters, who probe for the facts surrounding the loss of the house. For borrowers who faced genuine financial hardships leading to foreclosure, underwriters are likely to be more sympathetic a few years down the road.
Anyone thinking about joining the growing "walkaway" trend, where homeowners stop making payments and instead are sending lenders their keys, also known as "jingle mail", may wish to reconsider their prospective actions. The walkaways, typically, are people who can afford their mortgage but don't want to pay on a loan that is more than their house is worth so, they reason they'll live with the stigma or credit ding from a foreclosure just to get out from under their loan. These willful tactics are pushing up foreclosures, particularly in metropolitan areas where home prices have seen double digit declines in the past year. To combat the incipient trend, Fannie Mae and Freddie Mac, the country's two largest sources of mortgage money have issued a warning: if you walk away, don't expect to get a new home loan "certainly not one with favorable terms" for five to seven years.
In California, Florida and Nevada, the sites of once booming housing markets, the walkaway trend has become especially prevalent as many homeowners find themselves upside down on their loans, owing tens of thousands more than the current market value of their houses. If they invested little or nothing in down payments, some owners reason that by continuing to make payments, even if they can afford to, it's just throwing good money after bad. To pander to this growing market, a number of websites have popped up claiming to cut the hassles of bailing out of a mortgage. One company promises that clients "will be able to live in (the) home for up to eight months with no mortgage payments," after paying $895 for a customized plan. The same site says it will provide clients with "legal credit repair" to "improve your FICO scores." Another website claims that "your credit can be repaired and (you will) be able to purchase a house in as few as two years"*after paying a $495 fee. Still another company says walkaways can expect "up to one year living payment free" as the lender goes about filing for foreclosure. That company charges $995 for its how-to-do-it kit.
Fair Isaac Corp. of Minneapolis, the developer of the FICO score used in most mortgage transactions, is less than pleased by any suggestion that a foreclosure or walk-away could be minimized or wiped away in so short a period of time. Its scoring model counts walking-away as a long-standing and severe event, nearly comparable with bankruptcy, with negative consequences for all forms of credit that walk-aways might seek to obtain. That includes credit card applications, auto loans, student loans and even insurance and employment.
While borrowers facing foreclosure may have to contend with a host of unsavory consequences like wrecked credit and excessively high interest rates on whatever credit they manage to obtain, walkaway borrowers, no matter what some promoter may have promised online, will receive no sympathy and the IRS may demand income taxes on the balance they never paid.
Copyright © 2020 Rod Haase. All rights reserved.