Homeowners who cannot pay the mortgage may be desperate to get rid of their obligation. There are many options available: refinance, loan modification, short sale, deed-in-lieu of foreclosure, foreclosure or bankruptcy.
Lenders report these transactions to credit bureaus. In many cases, a mortgage solution significantly damages the borrower's credit score, also known as the FICO score.
"The single worst thing any person can do to her FICO score is to have a serious delinquency such as foreclosure or bankruptcy appear on her credit bureau report," says Craig Watts, public relations director for FICO, which developed the FICO score.
Damaged credit can make life miserable for borrowers, making it more difficult to secure a future mortgage or other loan, rent an apartment or even get a job.
A mortgage solution's potential to damage a credit score depends on a borrower's individual financial circumstances and past credit history, Watts says.
"The impact that serious delinquencies have on FICO scores can vary from person to person, based on what other information is on the person's credit bureau report," he says.
Watts says that FICO 08, a revamping of the credit score formula, will not alter how mortgage solutions affect a borrower's credit score.
"As have all our previous updates to the formula, our FICO 08 formula gives appropriate weight to consumer credit information -- including foreclosures -- based on the way consumers have handled credit obligations recently," Watts says.
Foreclosure and bankruptcy
A foreclosure can make a significant negative impact on a borrower's score.
Attorney Michael Hollman, with Village Settlements in Gaithersburg, Md., says he's seen as much as a 300-point drop in the FICO scores of clients who have a foreclosure listed on their credit reports.
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A foreclosure will remain on a credit report for seven years, according to FICO's myFICO Web site. However, a FICO score may begin to rebound in as little as two years if the borrower keeps all other credit obligations in good standing, according to the site.
“A court judgment posted to a person's credit report will almost always negatively impact her FICO score.”
According to the Web site, "The important thing to keep in mind is that a foreclosure is a single negative item, and if you keep this item isolated, it will be much less damaging to your FICO score than if you had a foreclosure in addition to defaulting on other credit obligations."
Some homeowners who face foreclosure may turn to the bankruptcy process for help. According to the National Consumer Law Center in Boston, a bankruptcy may make it possible to stop the foreclosure process, allowing borrowers to catch up on missed payments.
Travis Hamel Olsen, president of the National Short Sale Center in Scottsdale, Ariz., says borrowers also can use bankruptcy to discharge other debts, freeing up money for the monthly mortgage payment.
However, the reality is that in many cases, a bankruptcy just buys time until the homeowner defaults again on the loan, Olsen says.
In addition, a bankruptcy may have a greater negative impact on a borrower's FICO score than a foreclosure, according to the myFICO Web site."While a foreclosure is a single account that you default on, declaring bankruptcy has the opportunity to affect multiple accounts and therefore has potential to have a greater negative impact on your FICO score," the site says.
A bankruptcy remains on a credit report for seven to 10 years, depending on the nature of the bankruptcy.
Short sales and other alternatives
Bankruptcy is not the only alternative to foreclosure. A substitute is a short sale, which occurs when a lender agrees to allow a homeowner to sell a property for less than what the owner still owes on the mortgage.
A deed in lieu of a foreclosure is another alternative. It occurs when homeowners deed their home to the bank without going through the extra time and cost of a lengthy foreclosure process.
"Homeowners can only qualify for a deed in lieu of foreclosure if they have just one mortgage or if they have multiple liens from the same lender," Olsen says.