Credit scoring remains one of the major mysteries at play in the quest for a home loan mortgage. Lenders want to gauge the potential risk involved when they extend a mortgage loan to a homebuyer, and most turn to credit scores to help determine the credit risk associated with the prospective buyer.

Fair Isaac is the guru that produces the FICO scores used in the vast majority of lending decisions. FICO scores range from 300-850 and can affect how much money a lender will lend and at what interest rate and terms. Three major credit reporting agencies, or credit bureaus — TransUnion, Equifax and Experian — are the collectors and the keepers of the consumer credit information that is the basis for computing FICO scores; each credit bureau computes its own separate score. The credit bureaus track various credit information regarding, for instance, a person’s credit accounts, how many times lenders have requested credit information (inquiries), and how many times lenders used a collection agency to collect amounts that were due (collections).

The big hits: short sale, deed in lieu, foreclosure and bankruptcy

Recent years have been unkind to many consumers who have found themselves underwater on mortgages they cannot afford or who have struggled due to job loss, medical bills, divorce or other financial adversity. In the depths of despair and mortgage delinquency, many of these homeowners end up extricating themselves from their mortgage predicament by selling the property through a short sale, giving the lender a deed in lieu of foreclosure, allowing the bank to foreclose, or declaring bankruptcy. All of these events have an adverse impact on the individual’s credit score. While many might assume that the consequences of a short sale would be less drastic than the consequences of a foreclosure, when it comes to credit scores, the “hit” sustained may be the same.

Short sales 

With a short sale, the owner fashions a solution, with the cooperation and consent of the lender, of course, that causes the lender to accept less than the amount due. The short sale also saves the lender from the time and costs of a foreclosure. While that may be true, the purpose of the credit score analytics is to evaluate and project the risk the individual poses when credit is extended: will the individual repay a new loan or will the person default? A short sale’s impact will depend on how the short sale is reported to the credit bureaus. Because there is no specific code for a short sale, it often is reported as paid in full for less than the full balance, a negative code.

Foreclosure

If there is instead a foreclosure, there will be a derogatory effect on the person’s credit score that may be substantial, possibly as much as 200 points. A foreclosure remains on the credit report for seven years, but the impact will lessen over time, especially if the individual keeps other credit obligations in good standing. The foreclosure is less damaging if it is the only default or negative event in the credit file.

Gauging the impact

All negative mortgage events such as a short sale, foreclosure, or deed in lieu do not bode well for future credit risk because the individuals have not paid their mortgage debts. The exact impact in all cases depends on the credit score the person had before, what information is reported and the composition of his or her credit file. A lower starting credit score may drop less than a score that was higher to begin with. The impact is less extensive for consumers who had already missed payments or carry heavy debt loads. Conversely, the downward impact will probably be greater on the credit scores of consumers with no other delinquency or derogatory items and low debt levels. For example, if a person with a credit score of 680 has a foreclosure, the score will drop 85-105 points, while a bankruptcy drops the score 130-150 points. A person with a 780 credit score has more to lose: the foreclosure will mean a reduction of 140-160 points while the bankruptcy can take it down 220-240 points. Visit www.myfico.com/crediteducation/questions/Credit_Problem_Comparison.aspx for other examples. In all cases, a negative mortgage event such as these will ultimately result in fewer offers and account approvals and higher interest rates and fees. 

Isn’t a foreclosure worse than a short sale? 

FICO conducted a study to determine the credit risk associated with “mortgage stress events,” such as foreclosures and short sales, by analyzing data from 2009 through 2011. The results show a slightly better risk for persons who had short sales rather than a foreclosure, but the difference was not enough to cause FICO to score this differently. Approximately half of those individuals going through a short sale also defaulted on another account within two years, and many had another mortgage delinquency in their past.

Deed-in-lieu

A deed in lieu is also considered to be derogatory. While it may seem that it should bode better for a property owner who deeds the property to the lender rather than making them go through the time and expense of a foreclosure, the FICO score does not “look at it” the same way. In terms of predicting future credit risk, the negative impact of a deed in lieu of foreclosure and a foreclosure may be similar. Again, the specific impact depends on what the credit score was before and what other “black marks” are contained in the credit files with the credit bureaus.

Bankruptcy

A bankruptcy can do more credit score damage than a short sale, deed-in-lieu or foreclosure because it is a reflection of a person’s overall credit status rather than one hopefully isolated derogatory event. A bankruptcy can reduce otherwise good scores by 200 points or more, but will have less of an impact on low credit scores that already take into consideration past due status. The impact will gradually lessen over the 10 years it will remain on the credit report. 

Credit score repair and improvement

If an individual has experienced a credit score hit, or simply wants to improve his or her credit score, what can be done? Although it may seem obvious, the most important things that can be done immediately are:

1. Check the credit report: Credit score repair begins with the credit report. Check to make sure it contain no errors, particularly any late payments incorrectly listed or incorrect amounts owed. Dispute any errors with the credit bureau. 
2. Set up payment reminders: Making credit payments on time is one of the biggest contributing factors to a credit score. Consider enrolling in automatic payments through credit card and loan providers.
3. Reduce the amount of debt owed: Stop using credit cards. Pay down the highest interest cards first while maintaining minimum payments on other accounts.

Payment history tips

The payment history accounts for 35 percent of a credit score calculation, so it presents the best opportunity for improving a score, but past problems like missed or late payments are not easily fixed.

1. Always pay bills on time. Delinquent payments, even if only a few days late, and collections can have a major negative impact on a FICO score.
2. If payments are missed, getting current and staying current is the best medicine.
3. Paying off a collection account does not make it go away. It stays on the credit report for seven years.

Amounts owed tips

This category contributes 30 percent to the credit score calculation.

1. Keep balances low on credit cards and other revolving credit because high outstanding balances affect the credit score. Don’t exceed 35 percent of the credit card limits.
2. Pay down debt rather than moving it around. Owing the same amount but having fewer open accounts may lower the score.
3. Don’t close unused credit cards as a strategy to raise a credit score. 
4. Don’t open a number of new unneeded credit cards just to increase available credit. This approach could backfire and actually lower the credit score.

Length of credit history tips

Don’t open several new accounts too rapidly because they will lower the average account age. Leave older accounts open to maintain length of credit history.

Types of credit use tips

1. Apply for and open new credit accounts only as needed.
2. Having credit cards and installment loans and using them responsibly rebuilds a credit score. Someone with no credit cards, for example, may be higher risk than someone who has managed credit responsibly.
3. Closing an account doesn’t make it go away; it still shows up on the credit report. 

Free credits reports

The Fair Credit Reporting Act (FCRA) requires each of the nationwide consumer reporting companies — Equifax, Experian and TransUnion — to provide a free copy of an individual’s credit report, at his or her request, once every 12 months. Annualcreditreport.com is the ONLY authorized source for the free annual credit report that’s required under federal law. Many companies claim to offer free credit reports — and some do. But others give you a report only if you buy other products or services. 

The three nationwide credit bureaus have a central website, a toll-free telephone number, and a mailing address for ordering a free annual report. To order, visit annualcreditreport.com, call 1-877-322-8228, or complete the Annual Credit Report Request Form and mail it to: Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348. The form is available from www.ftc.gov/credit. Do not contact the three nationwide consumer reporting companies individually. 

There is no service where a person can obtain their credit score for free in order to simply check on it.

Debbi Conrad is Senior Attorney and Director of Legal Affairs for the WRA.