Avoiding Foreclosure: Loan Modifications Don’t Have Negative Impact on Credit Scores

A recent survey showed that most loan modifications have actually very little effect on a person’s credit score. The results of the survey conducted by VantageScore Solutions and involving over 400,000 active consumer credit files run contrary to the popular belief about loan modifications and their impact on credit ratings.

In a report, FoxBusiness reported that knowledge on the impact of loan modification on your credit score is important in this economy given that the number of mortgage holders 60 days or more late on their payments rose 6.67 percent in the second quarter of this year. This represented a drop from the first quarter (6.77 percent) but was an increase from 5.81 percent during the same period last year.

The same report said mortgage holders should be aware that a loan modification may help them keep their homes and at the same time preserve their creditworthiness.

Accordingly, drastic mortgage option like short sales (a sale where the proceeds are less than the balance owed on the loan) and foreclosures can cut a credit rating by 100 points or more, some loan modifications may benefit both the borrower and the community.

Foreclosures are known to have a negative impact on a community. Citing a study by Harvard University and the Massachusetts Institute of Technology, the report said a foreclosed home may lose its value by up to 27 percent and bring with it a reduction in the value of neighboring homes within 250 feet by as much 1 percent. Multiple foreclosed homes in a community can lower the value of nearby properties by several percentage points, the study said.

As a homeowner opting for loan modification to avoid foreclosure, you should know how it will impact your credit rating.

As a start, the impact will depend on a person’s starting credit score and his or her use of available credit, the FoxBusiness article said. As an example, a loan modification with no partial charge-off and in which the original loan is overwritten by the modified loan, could potentially add points to a credit score if the loan is not classified as new. A charge-off is where a portion of the debt is deemed uncollectible and is subsequently written off.

This positive result happens because the partial written off of principal will lessen the consumer’s overall percentage of credit amount used or owed on accounts, known as “utilization,” which helps the score, the report said.

This condition stays true as long as the existing loan stays intact and is not replaced with a new loan, thus preserving the “age” of the account. Even when a person’s original loan is overwritten and reclassified as new, the study shows the decrease in credit score to be minimal, without a partial charge-off.

For loan modifications where overdue mortgage payments are added to the principal balance of the loan, known as “recapitalization,” the credit 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 offset partially by the loss of the existing account age. The same effects can be observed for recapitalization as with forgiveness of subordinated loans.

On the other hand, the study also shows that individuals who remain current on their mortgage, but become late with other debts suffer a large decrease in credit score compared to those persons who keep all their accounts current. The drop increases dramatically if a homeowner becomes late on a mortgage. In this case the negative impact to a credit rating arising from delinquency is severe.

Overall, the results indicate that it’s much better to seek out a loan modification before you “experience a severe delinquency in a credit file,” FoxBusiness reported. “Late payments have a far greater impact on a credit score than loan modifications.”

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