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COVID + Credit: How a Short Sale or Foreclosure May Affect Your Credit Scores

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There are few events in life as painful as losing your home. The emotional impact of having your home taken away can be profound. Additionally, it may have an enormous effect on your financial well-being for years to come, including your ability to secure credit.

If you find yourself up against the wall and unable to continue paying your mortgage, don't give up hope. Instead, start taking charge of the situation by understanding your options.

Short sales

It's a commonly held belief that a short sale of your home does less damage to your credit scores than a foreclosure. That's generally not true.

When you signed your mortgage, you made a promise to the bank that you would pay back the loan. The bank then put a lien on your property. That means if you fail to follow through with your obligations, the lender reserves the right to sell the property and recoup its investment.

A short sale can occur when the bank agrees to remove the lien on your property, which allows you to sell the home even though you're no longer making mortgage payments.

While there are benefits to this approach, which are elaborated below, from a credit perspective, there's really no difference between a short sale and allowing your home to go into foreclosure. According to the three nationwide credit bureaus (Equifax, Experian and TransUnion), a short sale may show up on your credit reports as “not paid as agreed,” which means the lender received less than the full loan amount originally agreed upon. Because short sales and foreclosures both fall under this umbrella category, most lenders won't distinguish between the two, and both stay on your credit reports for seven years.

Here's how a short sale works: When you sell your house, all proceeds usually go to the lender. This doesn't necessarily mean you paid back your mortgage. Often, there's something called a deficiency, which is the amount still due on your mortgage after the proceeds of the sale are sent to the lender.

What are your obligations regarding the deficiency? Some lenders may ask you to sign a new promissory note saying you'll pay the remaining debt, while others may simply reserve the right to bill you for the debt. A bank can begin attempts to collect the money from you immediately after the short sale closes, and some lenders may turn the matter over to a collection agency. However, certain states have laws in place preventing banks from seeking this deficiency payment.

The main benefit of a short sale is the possibility of being forgiven for a portion of your loan. That scenario, however, doesn't play out for everyone. You will need to reach an agreement with the lender that you won't be held responsible for your remaining loan balance after the property is sold.

Foreclosures and Coronavirus/COVID-19

If an attempt to pursue a short sale has failed, you may enter foreclosure proceedings, which can also seriously damage your credit scores.

Fortunately, for people who are struggling to keep up with mortgage payments, federal officials have announced a temporary nationwide halt to foreclosures and evictions for federally-backed mortgages.

If you're one of more than 30 million U.S. adults whom this decision is projected to impact, you should be temporarily protected from losing your house as a result of the Coronavirus/COVID-19 pandemic. If you have lost your income (whether because of a business shut down, unpaid sick leave or another reason related to the virus), you may qualify for reduced or suspended mortgage payments for up to a year. You must contact your loan servicer to request this forbearance. 

If your mortgage is held by Fannie Mae or Freddie Mac, check with them, as both are offering aid to their borrowers. Visit FannieMae.com or FreddieMac.com to determine the best way to apply for mortgage relief, and look out for daily updates.

Homeowners cannot just stop paying their mortgages. You will first need to get in touch with your loan servicer to devise a payment plan that works for both parties. Your lender will determine if you're eligible for aid and how you can make up any late or missed payments. Importantly, the plan you and your lender agree to will not forgive your debt or give you cash. Instead, it will help you stay afloat until you recover financially. This may include extending your loan term or allowing you to make interest-only payments for an agreed amount of time.

Homeowners can find more details about the federal foreclosure and eviction moratorium and related Coronavirus/COVID-19 resources via the U.S. Department of Housing and Urban Development's website.

Foreclosures and your credit

Foreclosure is usually second only to bankruptcy as the event that does the most damage to your credit scores:

First, on your credit reports, as with a short sale, the account will often be flagged as “not paid as agreed.”

Second, while a foreclosure stays on your credit reports for seven years, that doesn't mean your credit scores are completely ruined. While your scores may drop, you can mitigate the damage by ensuring that all other aspects of your financial life are in good shape.

Ultimately, the effect of a foreclosure on credit scores differs from borrower to borrower. Some homeowners with strong credit scores may see their scores drop by as much as 100 points or more after suffering a foreclosure. Homeowners with lower credit scores may see a smaller decline, but only because there's less room to fall.

While your credit scores may be hit hard, there's plenty you can do to immediately begin rebuilding your scores. Paying your bills on time and using credit cards responsibly can go a long way toward repairing the damage. As long as your other accounts are in good standing, you could be back on track within two years because credit score providers often attach more weight to events that happened in the most recent 24 months.

Regarding future credit decisions, each lender may interpret a default on a mortgage loan differently. Some businesses may be much more likely to extend credit to you than others. For example, you may have more trouble being approved for a large loan to purchase an expensive item, such as an automobile, than you would for a new credit card. This is because a mortgage transaction is closer in magnitude to a car purchase than it is to opening a new credit card account.

Keep in mind that it's generally more difficult to get a lender to take a risk on you based on your previous performance. Therefore, you likely won't be able to qualify for a loan to purchase a home again for seven years, the length of time the foreclosure will remain on your credit reports.

Ways to avoid a short sale or foreclosure

Here are a few options that may have a less severe effect on your credit scores.

Loan modification: This option involves permanently changing your mortgage. For example, the lender may agree to reduce your interest rate or give you more time to pay off your past-due amount. You may also qualify for the federal government's Home Affordable Modification Program, which would give you a chance to change the terms of your mortgage.

Loan refinance: If you aren't terribly behind on your payments, you could work with your lender to lower your monthly payments by refinancing your mortgage. If done ahead of time, this would likely have no significant impact on your credit scores. You may be eligible for the government's Home Affordable Refinance Program.

Forbearance agreement: If you are falling behind on your mortgage payments for a temporary reason, such as short-term unemployment, you may qualify for mortgage forbearance. Under a forbearance agreement, the lender would suspend or reduce your mortgage payments for a period of time, after which you would pay back your missed or reduced payments.

Deed-in-lieu of foreclosure: There is a less common option that many believe may have a smaller negative impact on your credit scores than a foreclosure or short sale. Deed-in-lieu of foreclosure means you give the lender your home (or “deed”) in exchange for canceling your loan. The bank may agree to either halt foreclosure proceedings or not pursue foreclosure at all.

It is likely, however, that you will have to attempt to sell the property yourself for at least three months before a lender will agree to a deed-in-lieu of foreclosure. The bank would much prefer that you expend the effort to sell your house than to take on that burden itself.

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