Credit Reporting Industry’s Decision on Loan Modifications Boxes in Consumers
A recent Bloomberg article "Unintended Consequences of Mortgage Modifications: Falling Credit Scores" addresses a topic that deserves serious follow up. The article accurately identifies that loan modifications could damage your FICO credit scores, if they are reported to the credit bureaus using the new reporting guidelines set up by the credit bureaus and their trade organization, the Consumer Data Industry Association (CDIA).
A loan modification is simply a temporary modification of your mortgage loan terms. Normally the interest rate is adjusted to yield a lower and more affordable payment, allowing the homeowner to remain in the house and avoid foreclosure. There is no reduction of the principal amount you owe and the lender is not forgiving you of any of the debt. And the lower interest rate and payment are not permanent.
The issue at hand is how very large mortgage lenders, namely Citigroup, Chase, and Bank of America, may report mortgage loan modifications to the credit reporting agencies and, secondly, how that credit reporting impacts the consumers’ FICO credit scores. According to the Consumer Data Industry Association, the credit bureaus have agreed to guidelines that loan modifications will be reported as a "Partial Payment Plan."
The problem with this decision is that FICO credit scores interpret the notation of a “Partial Payment Plan” as negative. Consumers will see their scores decrease some amount of points because of such a classification. How much their scores decrease will depend on from where their scores started. A score of 550 isn’t going to plummet the same number of points as a score of 750.
“With a standard loan modification, a lender would not be losing any of their principal loan amount; therefore, a derogatory mark for a rate reduction or term extension would be very hard to justify”, according to Maz Badie a mortgage lender and creator of LoanModDVD.com. “It (a loan modification) would be the same thing as a credit card company lowering a cardholder's rate to zero percent for six months or a lender deferring a student loan because of the lack of jobs in the work place, neither of which has a negative impact on their credit scores.”
This Partial Payment Plan classification appears to box in tens of millions of consumers who are stuck in upside-down mortgages, which may or may not have adjustable terms. Every option available to consumers, other than selling their home for an amount sufficient to cover all of their mortgage loans in full, could damage their credit scores, and severely in some cases.
The options are:
Short Sales – Short sales are reported as either a charge off, a settlement, or the initial steps of the foreclosure process, depending on the loan and depending on the lender. Each of these is considered negative by FICO.
Foreclosures – These are reported as such and are considered negative by FICO.
Forfeiture of deed in lieu of foreclosure – Also called a voluntary foreclosure. These are reported as such and are considered negative by FICO.
Short refinances – A short refi is when you refinance your home with the same lender but they forgive some of the principle balance. I’ve seen these reported as settlements or charge offs and both are considered negative by FICO.
Loan Modifications – The lender changes the terms of the loan temporarily but does not lower the balance. This is reported as a partial payment plan and is considered negative by FICO.
I believe the decision to knowingly set reporting guidelines in such a way that the reporting damages consumers’ FICO scores was done arbitrarily, without sufficient research, and could unnecessarily harm consumers. This quote from FICO in the Bloomberg article leads me to this opinion: “FICO might study whether penalizing borrowers for such loan adjustments is valid as more changes are completed under the Obama administration's housing plan.” What this means is FICO, my previous employer and the company responsible for developing the FICO credit scoring system, wasn’t given the opportunity to look into whether or not consumers who have had their loans modified pose any more credit risk than consumers who have not had their loans modified.
According to Stuart Pratt, President of the Consumer Data Industry Association, “…how a FICO score treats that coding (Partial Payment Plan) and to the extent that the code today is considered as adverse and results in a score drop, that’s something FICO should speak to.” The way I see it, FICO should have been part of the discussion prior to the industry deciding how loan modifications were reported. Anyone who has their Citi, Chase, or Bank of America mortgage modified may see their scores damaged long before any research is done to determine if the damage was warranted. Someone has decided to put the cart before the horse on this issue.
John Ulzheimer is a nationally recognized credit expert, president of Consumer Education for Credit.com and contributor to On The Money. Learn more about him at CreditExpertWitness.com.