Ever since the collapse of the housing bubble some three years ago, there's been a lot of finger pointing as to whether to blame the government, the banks, or a combination of both. Regardless of who is at fault, the bursting of the housing bubble came down to the fact that too many people who could not afford mortgages were being approved for them, simply so that they could be part of the "American dream."
When the reality hit that many of these homeowners could not afford their monthly mortgage payments the banks and mortgage houses ended up in serious financial trouble and the housing market collapsed. The fallout of the collapse led the federal government to establish loan modification programs to help forestall foreclosures.
Although mortgage modifications have not helped very many people since being established, those who have been able to secure them have been saved from imminent foreclosure. While that provides good relief in the short-term, is it necessarily a good thing? Is it possible that modifying your mortgage could affect your credit rating more negatively than simply allowing your house to foreclose? Those are interesting questions we'll attempt to answer in this article.
Modifying Your Mortgage Will Affect Your Credit Score
When mortgage modification programs first began, banks had no way to classify them for internal credit purposes. It was a completely new vehicle that no one had ever dealt with. As a result, most banks used an old code which already existed; a code that normally indicated a borrower was either delinquent on payments or was only making partial payments. For someone who modified his mortgage, this code on his credit report would automatically mean a drop in his credit score anywhere from 30 to 100 points.
Realizing that this code would be unfair to homeowners who had not missed any payments, or made partial payments, the banking industry came up with a new code to apply to loan modifications. As long as a homeowner was current on all his payments at the time his loan was modified, his credit score would not be negatively affected. Consumers who did have payment issues would still be given the old code which would affect them negatively. This solution seemed to work well on paper, but in reality it was not any better.
The reality is that individuals who need a loan modification are generally applying for them to forestall foreclosure. That means that such individuals are automatically at risk. Even a loan modification which is able to take several hundred dollars a month off a mortgage payment still barely gives the homeowner enough breathing room to account for things like a lost job, and extended illness, etc. Even with the new code banks still are wary of individuals who have loan modification. So while the new code may not necessarily lower your credit score, bankers will still take it into account.
The Long-Term Effect
While foreclosures are never good, they typically only remain on your credit report for 7 to 10 years. A foreclosure will obviously cause a drastic drop in your credit score and make it very difficult for you to get new credit until it is erased. Yet consider having the loan modification code on your credit history for the life of a 30-year mortgage. Even worse, imagine if you had the old code that indicates you had some payment problems. You're looking at potentially 30 years of an unfavorable credit report as opposed to the 7 to 10 years from a foreclosure.
Thankfully, banks understand this discrepancy and are rethinking their credit evaluations accordingly. They obviously don't want to encourage foreclosures because that will inevitably cost them way too much money. So while banks are still legally free to consider a mortgage modification as part of your credit history, many are forgoing that option as long as borrowers make good on their payments in the future. Usually within a couple of years of modifying your mortgage it should have no effect on your credit score.
Going the Extra Mile
If you are one of the individuals who receive the old code for a loan modification because you were late with payments, there are things you can do to rebuild your credit score over time. Just remember that repairing your credit is a choice you must make, followed by self discipline and a specific course of action. You cannot simply hope your credit score will get better on its own. You need to take decisive action to show your creditors you are serious about getting your financial house in order.
Most important is to make sure that every mortgage payment is made on time. If your modified loan allows you to set aside some extra money, making one or two extra payments annually will not only boost your credit score, but also significantly reduce the amount of interest you'll pay on your loan. Suffice it to say that if poor performance on your mortgage is what damaged your credit, being faithful to your new mortgage will go a long way in repairing it.
Secondly, avoid establishing new credit for as long as you possibly can after modifying your mortgage. Every time you established new credit it goes on your credit history and potentially reduces your credit score. Examples of new credit you should avoid include:
- credit cards
- revolving lines of retail credit
- automobile loans
- personal loans
- home equity loans
Third, all of your outstanding accounts should be dealt with in the same serious and diligent manner as your mortgage. If you still are having trouble making your monthly payments after your mortgage has been modified, consider one of the options you have available to manage your outstanding balances. One option is to seek out a credit counseling organization that can consolidate all of your bills into a single monthly payment. These organizations can often renegotiate what you owe and significantly reduce your debt load.
Another option is to contact your creditors directly and work out payment plans with them. It's very rare for one to turn down your offer of a payment plan unless you've given them sufficient proof in the past that you're not trustworthy. But let's face it; they don't want to lose their money, so they're willing to wait a little longer as long as they get it. If more people understood this fact about their creditors they could save themselves a lot of potential financial trouble. Just call them and talk to them; you'll be surprised at the response you get most of the time.
Stay the Course
Finally, if you've had to modify your mortgage you should do your best to stay in your home for as long as possible. The term of the modified mortgage will typically be extended in order to reduce your payments, but every extension of your mortgage means you're paying more interest. You need to stay in your home as long as you can to build up enough equity so that when you sell it, you make back some of what you spent on interest. You'll obviously never get it all back, but there's no point in extending your mortgage, then selling your house three years later and losing all that interest money.