The recent news that nearly one in four American home owners is currently “underwater” with their mortgage is alarming. This isn’t an issue isolated to the poor and/or unemployed. Regardless of employment status or net worth, many people who purchased homes at the peak of the housing market face this dilemma. For some people, it’s relocation due to job change that creates a tough decision.
Another situation that is an unfortunate outcome of the bubble in housing regards people who were inspired to buy rental property or second homes at the peak of the market. Some people even refinanced their primary residence to pull out equity to purchase these properties. Now, some of them find themselves upside down on their refinanced home and on the other property they purchased.
Owners who owe more on their mortgage than they could sell their home or second property for have five options. Below is a list of these options and some information about how each could affect your credit score.
Option #1 – Continue to make payments
If the owner has enough cash flow and thinks that the value of the property will increase, he or she can continue to make the agreed upon monthly payments. This will help his/her credit score in the long run because it shows perseverance. It could also prove to be an expensive decision if the price of the house does not rebound.
Option #2 – Renegotiate or refinance the loan
The owner can try to revise the loan with the bank or lending institution. Often the lender won’t allow this until the owner misses multiple payments. Assuming the owner and the bank can agree to new terms (either a lower loan value or lower interest rate) this will hurt the average home owner’s credit score the least. A traditional refinance may be a better option given today’s low interest rates. Refinancing does have a cost hurdle and the qualification process has become more difficult.
Option #3 – Short sale
Some loan providers will agree to accept less than the full payoff balance for the loan if the owner can sell the house. This may be attractive to get out of the loan but it has drawbacks. The difference between the loan balance and the actual amount paid off is considered ordinary income to the owner. The IRS views this as if the loan provider essentially gave you the difference in cash. Income tax is due on that amount even though the owner never received any beneficial use of the “money.”
A short sale also does meaningful credit score damage. In some cases, 200-300 points can be removed from a good credit score. According to Consumer Reports.org, “if a loan modification or short sale is reported as ‘in partial payment,’ ‘deferred payment,’ or some other ‘not paying as agreed,’ your score could suffer substantial damage, even if that’s the only blemish.” The one good thing about this is that the period of time before the seller can get another loan is reduced to at least 24 months. More often than not, more time is required after a short sale before a bank or other lending institution will make another loan.
Option #4 – Foreclosure
The owner can stop making all payments and can live in the property for as much as four months before the bank forecloses on the property. The bank re-establishes ownership and the former owner’s credit score is usually reduced by the same 200-300 points as a short sale. With a foreclosure, the period before a person re-qualifies for a loan is increased to 5-7 years under Fannie Mae guidelines.
Choice #5 – Bankruptcy
The owner can declare bankruptcy and can essentially wipe out all of his or her liabilities. Of course this option extracts the most severe penalties as the total reduction in credit score tends to be 300 or more points and this can make it difficult or impossible to obtain a loan for many years.
These are tough choices for borrowers, but understanding these alternatives could help them better understand how to work through this issue.