Which is Best for my Credit Score?
Posted by Mark Martella on Wed, Oct 24, 2012 @ 1:15 PM
I am often asked when meeting with a client who is facing foreclosure as to how the foreclosure will affect their credit score. They then ask whether it is better to do a short sale, deed-in-lieu of foreclosure, simply let the foreclosure go through on its own or to file bankruptcy with regard to how much their credit score will be hit and how long it will take to re-establish a good credit score. However, the analysis is much more involved than just how the foreclosure will affect your credit score. You must also examine factors outside of just your credit score that lenders look at to determine whether you qualify for financing in the future.
The Effect on your Credit Score
From a practical standpoint, the differences regarding the effect on your credit score between a short sale, foreclosure and bankruptcy, is sort of like the difference between being hit by a truck or a bus. The end results are ultimately pretty much the same. According to Fair Isaac (also known as FICO), your credit score when facing a short sale, foreclosure or deed-in-lieu of foreclosure will drop anywhere from 85 to 160 points. Should you file bankruptcy, your credit score will drop anywhere from 130 to 240 points. If one were just to make a decision based upon the drop in one’s credit score, you would reach the conclusion that a foreclosure is better than a bankruptcy. However, further analysis reveals that such a conclusion is wrong!!! There are two main reasons why it is wrong.
The Foreclosure Process
First, if you allow the property to go through foreclosure, you still face the possibility of the lender pursuing you for a deficiency, which is the difference between the fair market value at the time the property is sold at public sale, and what you owe on the mortgage. For example, if you owe $200,000 on a mortgage and the property is only worth $125,000, you could face a $75,000 deficiency judgment. I have found more recently that banks are pursuing these deficiencies. However, if you were to file for bankruptcy, this $75,000 would be discharged and there is no tax consequence for the forgiveness of this debt.
A second reason why bankruptcy or a short sale is better than allowing a foreclosure to proceed to a foreclosure judgment and sale, is that you will be able to qualify for a mortgage loan by doing a short sale or deed-in-lieu of foreclosure, or even a bankruptcy, faster than if you have a foreclosure on your record.
Banks Follow Fannie Mae and Freddy Mac guidelines
I interviewed a number of local lenders with regard to their lending policies when it comes to a borrower who has faced foreclosure or bankruptcy. While each bank has its own guidelines, there is a general similarity of following the guidelines set forth by Fannie Mae and Freddy Mac. In my discussions with Marcia Cullinan, Vice President of Residential Lending for Encore National Bank, she concurred that while her bank will look at special circumstances, by and large, they will follow the Fannie Mae and Freddy Mac guidelines.
While the guidelines are too lengthy and complicated to go over in detail in this article, they can be summarized as follows:
1. Under the guidelines, your best option for purposes of obtaining a new loan in the future is to either do a deed-in-lieu of foreclosure (where you transfer the property back to the lender in exchange for a release of any deficiency) or a short sale, where you sell the property for less than what is owed on the mortgage. Under the guidelines, if you have a 20% down payment, you should be able to qualify for a loan 2 years after a transfer by a deed in lieu or short sale. If you are only putting down 10%, you would qualify for a loan after 4 years.
2. Should you file bankruptcy, under the guidelines, you would qualify for a mortgage after 4 years from the date of Discharge. In a Chapter 7, the discharge occurs approximately 6 months after you file and in a Chapter 13, the discharge can come between 36 and 60 months after you file. [I must also emphasize that during these time periods, it is presumed that you have done all the right things, that is, having no late payments and making all of your payments on time.]
3. The worst option is foreclosure under the guidelines. You would have to wait 7 years from the date the foreclosure judgment was entered before you qualified for a loan under the guidelines. Additionally, if a deficiency judgment was entered against you during that time, the deficiency judgment would also have to be paid off prior to you being able to close. Obviously for these reasons, the worst case scenario should you wish to get a fresh start is a foreclosure.
Bankruptcy vs. Foreclosure
In summary, although from a pure credit score, a bankruptcy may cause a larger initial drop in your score than a foreclosure, in the long run, the Discharge provided by bankruptcy, especially a Chapter 7, may be a quicker and more efficient way to get a fresh start and have the opportunity buy a new home in the future. Keep in mind that the foregoing is just meant as a general discussion of these issues and each person’s situation is different. That is why it is important to always consult with qualified professionals regarding your specific situation.
Some may qualify sooner while others may take longer. If you, a client, friend or family member are facing foreclosure or other financial issues, please contact us for a free consultation so that we can analyze your position and point you in the right direction.
Contact a Professional Bankruptcy Attorney
If you have a situation as we described in this article and have questions or concerns, please do not hesitate to contact us to answer your bankruptcy and foreclosure law questions.