Homeowners mulling a loan modification but are worried about how it might impact their credit score can relax. A recent VantageScore Solutions survey using more than 400,000 active, anonymous consumer credit files shows that mortgage modification options have very little effect on scores.
Knowing the facts about the credit score impact of loan modification is useful in an economy where homeowners continue to struggle to make mortgage payments. Statistics from TransUnion show that during the quarter ending June 30, the number of mortgage holders 60 days or more behind on their payments rose 6.67%, representing a drop from the previous quarter (6.77%) but an increase from 5.81% in the second quarter of 2009.
Mortgage holders also should realize a loan modification may help them keep their homes and preserve creditworthiness. More than 1.2 million homeowners already have entered a trial modification through the federal government’s “Home Affordable Modification Program” (HAMP) initiative, according to a July report from the U.S. Treasury Department and the U.S. Department of Housing and Urban Development.
You can click here to find a short questionnaire to help determine your eligibility for a loan modification.
While it’s true that more drastic mortgage options such as short sales (a transaction where the sale proceeds fall short of the balance owed on the mortgage) and foreclosures can slash a credit score by 100 points or more, some loan modifications may benefit both the borrower and the neighborhood.
Foreclosures can decimate a community. A recent study conducted by Harvard University and the Massachusetts Institute of Technology shows a foreclosed home may lose up to 27% of its value while reducing the value of neighboring homes within 250 feet by as much 1%. The same study also found that multiple foreclosed homes in a neighborhood can lower the value of other nearby properties by several percentage points.
So, if you’re a homeowner trying to avoid foreclosure by choosing a loan modification, you should know how it will affect your credit score.
To begin with, the impact will depend on your starting credit score and your use of available credit. For example, a loan modification with no partial charge-off (where a portion of the debt is deemed uncollectible and is subsequently written off), in which the modified loan overwrites the original loan, could potentially add points to a credit score if the loan is not classified as new. This positive result occurs because the partial forgiveness of principal will reduce the consumer’s overall percentage of credit amount used or owed on accounts, known as “utilization,” which helps the score.
This remains true as long the existing loan remains intact and is not replaced with a new loan, preserving the “age” of the account. Even when a consumer’s original loan is overwritten and reclassified as new, research shows the score decrease to be minimal, without a partial charge-off.
In the case of loan modifications where mortgage payments that are past due are added to the principal balance of the loan, a process known as “recapitalization,” the scores are slightly higher due to a higher credit amount on open real estate accounts.
If a new account is created, this positive effect is partially offset by the loss of the existing account age and similar effects can be seen for recapitalization as with forgiveness of subordinated loans.
Conversely, our research shows that consumers who remain up to date on their mortgage, but become late with other debts suffer a large drop in score compared to those consumers who keep all their accounts current. The drop rises sharply if a homeowner becomes late on a mortgage. So clearly, the damage to a credit score from delinquency is severe.
The bottom line is that it’s much better to seek out a loan modification before the consumer experiences a severe delinquency in a credit file. Late payments have a far greater impact on a credit score than loan modifications.
In the future, I am sure we’ll see more media coverage on the issue of loan modifications and the so-called “damage” they will inflict on a credit score, but consumers need to understand the greater damage done by delinquency rather than focus on the much smaller changes from loan modification programs.
Barrett Burns is president and chief executive officer of VantageScore Solutions, a company launched by the nation’s three major credit reporting companies (CRCs) - Equifax, Experian and TransUnion to offer VantageScore, a generic credit scoring model. He has more than three decades of professional experience in risk and credit management and has held a diverse number of national and international leadership positions with companies including U.S. Trust, Ford Motor Credit, Bank One and Citibank.