Do a Short Sale or Foreclose? Either Way Your Credit is Shot and It’ll Be Hard To Get a Loan in the Future!

Whether you foreclose, do a short sale or go through a deed in lieu of foreclosure your credit is shot. The extent to which your score falls may differ, but to any future creditor it is all the same. Not only that but when you apply for credit in a few years, its really important to not have any derogatory items on your credit report for at least 24 months prior to an application. For example lets say you do a short sale this month (June 2008) and you apply for a mortgage in June 2011. Then you should not have any derogatory items (late payments) since June 2009. Also, from the recent changes to credit guidelines it may be well after 2011 that you can even apply for a mortgage loan.

I had discussed this point in response to a visitor question back in December 2007. Recently another reader, who happens to be a very knowledge mortgage broker, left me a comment clarifying the current guidelines and how things are viewed today. I figured it would be to everyones interest to have the comments published as a post. So, below is the response from Catherine Coy to my post from last December “Will “Forgiven” Debt Affect My Credit Score?”

You’re very mistaken as to the impact of foreclosure vs. short sale vs. deed-in-lieu.

As a mortgage broker myself, I get many calls these days from consumers wondering what affect a short sale or foreclosure (or deed-in-lieu of foreclosure) will have on their credit. This is an important topic because the last real estate downturn (during the 1990s) preceded the widespread use of FICO scoring and automated underwriting systems.

Some real estate agents and short sale investors (those seeking to purchase a homeowner’s property prior to foreclosure)–and even some mortgage professionals–suggest to the distressed homeowner that a short sale isn’t as damaging to one’s credit as a foreclosure. Given the inherent conflict of interest—a real estate agent makes a commission on a short sale and doesn’t in a foreclosure—the real estate professional should proceed cautiously when counseling a seller. The practical reality is, short sale or foreclosure, one’s credit will suck either way.

Many mistakenly believe that a derogatory public record such as foreclosure is somehow worse than petitioning the lender to accept less than owed (short sale). In the world of banking, however, lenders interpret either of these events only one way: the customer did not pay as agreed. It matters not to a lender the manner by which it suffered a loss; only that it did. Lenders go to great lengths to alert each other, by way of reporting to credit bureaus, that the defaulting homeowner is someone who, when the chips were down, didn’t honor a contract.

In fact, lately Fannie Mae and Freddie Mac took an even stronger stand against homeowners who renege on their obligation. “Seasoning” of a foreclosure or short sale is now five years.

Fannie Mae Tightens Guidelines Again

In the world of FICO scoring, there are three credit events that will severely sink a FICO score, and they all carry exactly the same weight. They are (1) serious delinquency, (2) derogatory public record or (3) collection filed. A homeowner in default is technically “in collection.” These events are reported to all three bureaus as “Score Factor Code #22.”

A foreclosure will remain on a consumer’s credit report in the “public records” section for ten years. In addition, this fact must be attested to on the loan application under “Declarations,” Section VIII, as follows:

(c) Have you had property foreclosed upon or given title or deed in lieu thereof in the last 7 years? (Y/N)

(e) Have you directly or indirectly been obligated on any loan which resulted in foreclosure, transfer of title in lieu of foreclosure, or judgment? (Y/N)

Because the term “short sale” is not expressly stated, some interpret this as meaning that a short sale is a lesser offense. The truth is, decision makers in the lending industry know that a short sale is no different than a foreclosure or deed-in-lieu. Here are two excerpts from a lender’s underwriting guidelines.

The following items are subject to individual evaluation, no matter how high the
credit score:
• Bankruptcy, foreclosure, deed-in-lieu, short sale.
• Judgments, collections, charge-offs, tax liens.

~ and ~

None in past 4 years with minimum 3 active trade lines more than 24 months old, with no late payments or derogatory credit after the foreclosure.

Definition of Foreclosure: Any 120 day mortgage late within the last 24 months, any notice of default or settlement on a real estate secured trade line (short sale), any deed-in-lieu or forbearance agreements.

To the homeowner with a mortgage he can no longer afford, the decision to voluntarily vacate through a short sale or be forced out by foreclosure can be agonizing. The sterling credit reputation it may have taken a lifetime to establish is gone with a single event. Most landlords with whom I’ve spoken state that, due to the widespread credit meltdown, they would view a foreclosure as not particularly onerous—provided that all other credit obligations were met on time. A credit report riddled with “derogs” over a broad category of obligations would be viewed negatively.

For the homeowner who, if he remains in default, must eventually vacate his home, there may be an emotional advantage to avoiding the social stigma of the “F” word—foreclosure. He can tell himself and his friends, “I’ve never had a foreclosure,” but to his lender and the credit bureaus, foreclosure and short sale are exactly the same.

This article is intended not as a judgment of the motive or character of a homeowner in distress, but to present the facts so that no one is misguided. There’s no credit preservation advantage to short sale over foreclosure. The nation’s two largest mortgage investors, Fannie Mae and Freddie Mac—with certain exceptions—won’t lend again for five years. A consumer’s FICO score will take a huge hit either way until responsible credit behavior supplants the major hit of foreclosure/short sale over a period of time.

Loan Approvals Depend Entirely on Income Verification

I’ve written plenty about the importance of having a good credit score and maintaining a clean credit report. From getting a job promotion to finding the right spouse, your credit score can play a much more ubiquitous role than ever before. That was then, but this is now. In today’s changed lending landscape your perfect score doesn’t mean as much as the lenders ability to verify your income! It’s that simple. “Good credit, bad credit, any credit” doesn’t fly anymore. It’s more like “good income, verifiable income, consistent income”!

During the boom years (2002-2006) income verification during the mortgage application process pretty much fell by the wayside. Lenders were not paying too much attention to where you made your money, how you made it and the likelihood of it continuing for the next three years. They simply looked at your credit score and “assumed” you’d be able to make the monthly payment. I know that is somewhat of an exaggeration, but that is the exact kind of mindset lenders had and in many cases the root of the current credit problem.

Now that enlightenment has reached everyone from Alan Greenspan to hedge fund accountants, lenders have finally accepted the fact that borrowers need to be able to make the monthly payment. This realization is turning lenders old fashioned grumps demanding to see proof that your employer exists, your check is real and that you indeed have a certain career stability. This means if you fill out a mortgage application today you will be asked detailed questions regarding your income and employment and depending on your exact situation the level of scrutiny can vary significantly.

For regular full time salaried borrowers receiving W2’s at the end of the year, the requirements are minimal. All you need to do is furnish a few recent pay-stubs and a copy of your most recent W2 and you’re essentially good to go. If you receive more than 25% of your income in the form of commission then you may need to furnish two years of tax returns. The clunker on these is any un-reimbursed employee expenses that reduced income. That can make your effective earnings lower and decrease the amount you can afford. Additionally, a decreasing commission income trend will also play a factor in the under writing decision.

Life is most difficult for the self employed borrower with the smart accountant. Don’t forget that self-employed also includes those who receive 1099 income as well – so its not just a business owner. Two years of personal tax returns is universally required in these cases but I am starting to see requests for two years of business tax returns as well. Of course, the tax returns always show a very low income and unfortunately there is very little that can be done to account for this lowered income. This is because the lender will make the loan decision on the taxable income – and in many cases the income is simply too low. There are some things which can be added back to the income but only very much. The five or six times I’ve gone through this process for a self employed borrower I haven’t been able to add a whole bunch back to their income.

As you can see, it’s a different world out there. It’s still very important to have good credit and all the other things like down payment, but income verification is increasingly more important. The only real way to make income less important in the credit evaluation process is to put more money down. If you are able to put 25% or more down then in many cases I’ve seen the income verification requirements reduced. However, not everyone is in a position to make a higher down payment.

Does a Higher Down Payment Compensate For a Low Credit Score?

A reader reacts to my post titled “Why Lenders Care About Credit Scores” and sends this excellent question:

How much more of a positive effect does putting a greater percentage down on the home purchase vs. a low credit score.

For example, if I have a credit score of 620, but put down 20% down, how much more “pleasing” is this to a lender vs. if I have a credit score of 750, but put 0% down (or only 5%).

Again, this is an excellent question.

In a regular conventional loan, a higher down payment significantly improves your chances of obtaining an approval. So, if you had a 640 score and put 20% down, you’re more likely to get an approval than with only 5% down. So, in that sense a higher down payment is more “pleasing” to the lender. In the case where the credit score is already very high, then the down payment doesn’t play as much of a role. Meaning, whether you put 5% down or 20% down you will most likely get an approval in either case.

Going back to your question, when you have a score as low as 620, putting a higher down payment will help; but it’s still harder to get an approval compared to putting 5% down with a 740+ score. While the down payment helps, it still does not completely mitigate the possibility that the borrower has had serious credit issues in the past. Having said that putting more than 35% down changes everything. Lenders will most likely lend at any reasonable score with so much down as long as other factors are acceptable.

In terms of loan interest rate the new guidelines stipulate rates based solely on the borrowers credit score. So, whether you put 5% down or 20% down your interest rates will be higher if you have a score less than 680.

Bear in mind these rules apply to conventional loans. If you do the FHA program then these rules have no bearing. The FHA program is not credit score driven and hence will not factor in your score to the same extent as conventional. Also, FHA assumes you will not put any money down (it’s a 97% program and 3% to come from gifts). The approval is based on an overall picture involving your income/employment, liquid cash reserves, borrower credit and property type.

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