By Barry Paperno
I recently wrote about the negative impact of short sales and foreclosures on credit scores, and how such a mark on your credit report can knock as much as 160 points off your score.
While intuitively this kind of severe impact isn't so surprising in the case of a foreclosure, some people are surprised that this same impact can be felt following a short sale or mortgage modification. Some even argue that FICO scoring is too hard on consumers who "do the right thing" by working with their lender toward a short sale or mortgage modification, versus simply walking away from their obligations (aka strategically defaulting) -- especially when you consider that the drop in home values is not their fault.
Harsh treatment or not, and despite the responsible consumer behavior demonstrated in these situations, when talking about the validity of credit scoring in predicting any kind of future risk, the question should always be, "what does the data show?"
When it comes to evaluating some of the credit risk associated with certain "mortgage stress events," FICO analyst, Frederic Huynh, answered that question this week in his FICO Banking and Analytics Blog post, "Are Short Sales Really That Bad." Huynh reveals the results of some recent FICO research that looked at data from 2009 to 2011 to see how consumers handled their other non-mortgage credit obligations following a short sale, foreclosure, deed-in-lieu of foreclosure, mortgage modification or other such outcome.
Good Credit Gone Bad
What this study shows overwhelmingly is that someone who encounters difficulty paying a mortgage -- regardless of how the difficulties originated or how they were resolved -- are much more likely to "go bad" on another debt within two years after such difficulty than those with clean credit histories.
How much more likely are they to go bad? Compared with those having a clean credit report, a consumer who has sold a home via short sale has more than a 50 percent chance of defaulting on another account within two years. That's the same likelihood of going bad on another obligation as someone with a 90-day (or worse) late payment, collection or derogatory public record (bankruptcy, tax lien, judgment) on his or her credit report.
In most cases, they've been late on a mortgage payment prior to the completion of the short sale.
Huynh also addressed the issue of mortgage modification by saying it's too soon to assess the link between this mortgage status and future risk, due to the relatively short time since the mortgage modification credit reporting codes have been in place (since 2010). Typically, it takes a full two years of data to adequately analyze the risk implications of any of these situations.
Nevertheless, FICO has given us a peek into some of the mortgage modification data they're researching by way of the "Partial Payment Agreement" statistics also included in this study, as this description is how many of the mortgages undergoing a loan modification are reported at the consumer reporting agencies. According to the data so far, a whopping 86 percent of consumers with mortgages in a loan modification appear likely to default on another account within two years.
So, while some of the FICO score treatment toward responsible consumers doing the right things might seem a bit harsh in the case of short sales and mortgage modifications, FICO has presented some strong evidence that, on the contrary, the score is doing its job.
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