As published in Scotsman Guide's Residential Edition, December 2008.
In today’s market, homeowners trying to sell their homes to avoid foreclosure find themselves in a tough spot. While many discover that they can’t sell their home for their asking price, selling for a lower price won’t cover their outstanding loan.
Either a short sale or a deed in lieu of foreclosure may be the answer for many of these homeowners. What they may not realize, however, is that these situations often result in the same credit-score drop as foreclosures. As a mortgage broker, you can advise your clients on why this is the case — and why, depending on their situations, short sales might be the best way to go.
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Before advising on such things, however, mortgage brokers must understand the difference between deeds in lieu of foreclosure and short sales.
Deeds in lieu of foreclosure: These occur when mortgage-holders agree to move rather than going through foreclosure.
Short sales: These take place when mortgage lenders agree to accept less than the full loan amount outstanding.
Lenders often view short sales as the more-desirable choice because homeowners attempt to sell their home and pay off their debt, rather than just walking away. For example, if someone owes $100,000 on their home and can sell it for $75,000, the lender could agree to accept the offer, forgive the outstanding $25,000 and take the loss. This difference is called a deficiency balance. In the past, homeowners were taxed on it, but the Mortgage Forgiveness Debt Relief Act of 2007 now excludes short-sale-deficiency balances as taxable income through 2009.
The impact on credit
Credit-scoring models view all settlements as negative indicators. And short sales are considered settlements. The lender will report that the account was settled for less than the full loan amount. That is, even though the loan has a zero balance, it was not paid in full according to the loan agreement’s original terms.
Further, short sales and deeds in lieu of foreclosure are just as bad as foreclosures when it comes to credit and credit scores. All three are likely to remain on the credit report for seven years.
Because there are so many variables used when calculating credit scores, it’s difficult to pinpoint exactly how much a score will drop. As an educated guess, however, the effect of these situations can range from 20 points if the person had a credit score of 500 before the event to more than 150 points if the initial credit score was greater than 720.
3 reasons to proceed
Although short sales can hurt credit scores, they may benefit some homeowners. Here are three ways a short sale can help your clients:
1. Flexible lender policies: Certainly, credit scores affect someone’s ability to qualify for a loan. In the mortgage world, however, there is still some flexibility when it comes to underwriting. The next time borrowers with a short sale seek a mortgage, they may find that attempting to satisfy their previous mortgage obligation instead of walking away from it works to their favor and serves as the difference between being approved or denied.
2. Personal responsibility: Fundamentally, borrowers are liable for the decisions they make and the loans they sign. Whether they’re in a bad mortgage loan because of market changes or because they made a poor choice, they have to bear some of the responsibility. If repaying the loan in full is impossible, repaying as much of it as possible is the next best action they can take. It’s also the ethical thing to do.
3. Potential lender omissions: Lenders sometimes make mistakes and simply report a zero balance with no mention of settlement. Though unlikely, it happens more often than most people think. If your client is one of the lucky few to whom it does happen, the credit score won’t be adversely affected — it may even increase because the loan was paid off.
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Mortgage brokers with clients facing foreclosure must be well-versed on the difference between short sales and deeds in lieu of foreclosure. They should also understand the effects on clients’ credit scores and how each client’s situation is different.
By making an effort to help clients navigate their difficult time, brokers will further establish their position as trusted advisers and increase their likelihood of receiving future business. Moreover, helping borrowers through the tough times is — much like making a best effort at a short sale — the ethical thing to do.
Edward Jamison is a credit attorney and founder of CreditCRM.com, which is a business-in-a-box system for opening your own credit-restoration business in-house.
He can be reached at (310) 268-0580, ext. 103, or via e-mail at firstname.lastname@example.org.