A Score Issue for Lenders to Settle
Loan modifications are still hurting borrowers' credit scores, but regulators and legislators say people's participation in such programs should end their delinquent status.
Lawmakers say that modifications are a sign that a struggling borrower might remain a good risk, and that there is no reason some commonly used credit scoring models should classify payments made through such programs as late.
The issue is becoming increasingly important for banks, which are trying to drive up new mortgage volume but may have trouble lending to the 3.2 million homeowners who have received permanent loan modifications.
"There is no way to scientifically prove that loan mods are an elevated risk that should influence a credit score," said John Ulzheimer, head of consumer education at the lead generator Credit.com Inc. and a veteran of Fair Isaac Corp. and Equifax Inc.
At the urging of Treasury Department, the Consumer Data Industry Association, a trade group representing the three major credit bureaus — Equifax, Experian PLC and TransUnion LLC — created a special status code last year for credit files that had been modified under the government's Home Affordable Modification Plan. Banks and servicers began using the new code for government mods in November. Loans modified by banks and servicers through their own internal plans have another new code that was put in place in August.
Norm Magnuson, a spokesman for the CDIA, said that by the time a borrower receives a loan modification, "they have taken a hit on their credit score already."
Borrowers' credit scores can fall by as much as 135 points once they fall three months behind on a mortgage, according to Fair Isaac, which created FICO scores, so by the time they receive a loan mod, their credit is in poor shape.
But legislators say that by pursuing loan mods, borrowers show they are trying to manage their debts responsibly — exactly the behavior that should be rewarded. The debate about credit scores will take on even more significance because banks are struggling to find qualified homebuyers to whom they can issue new mortgages.
Rep. Jackie Speier, D-San Francisco, has proposed legislation that would prevent banks and servicers from reporting modified loan payments as delinquent. Speier says that because homeowners have modified the loan with their lender, they have a new contract and should not have their credit score dinged for trying to save their home.
(Rep. Mary Jo Kilroy, D-Ohio, has proposed the Medical DebtRelief Act, which would amend the Fair Credit Report Act and prohibit medical debts that have been paid or settled from being used in assessing consumer credit scores.)
Craig Watts, a spokesman for Fair Isaac, the maker of FICO scores, said borrowers do not take a hit to their credit if a servicer uses either of the new codes because his company, which updates its model every two years, has "no basis for evaluating the codes, so it ignores them."
"They aren't taking a hit for that reporting status," Watts said.
But servicers often use more than one code when reporting payment information to the credit bureaus.
Many borrowers who are put into a trial loan modification may get assigned one of the new codes — but they also are reported as paying under a "partial payment plan," or "modified payment agreement," which is regarded as a serious delinquency by Fair Isaac, Watts said.
A delinquency stays on a borrower's credit report for seven years and statistically correlates closely with a high risk of default, he said. The more recent the delinquency, the greater the impact on a score.
"It all depends on how the lender reports to the bureaus," Watts said.
Because it can take lenders up to nine months to process a loan modification, Ulzheimer said credit reports should be shielded from having delinquencies reported if the borrower has become current.
He says there is little difference between a borrower getting a loan mod and those trying to refinance. Many borrowers who owe more on their loan than the home is worth cannot refinance and instead pursue a modification.
"You can't just say that people who get loan mods are a high risk when what they're after is a lower monthly payment, which is what everyone who refinances wants as well," Ulzheimer said.
Another problem for future borrowing is that the credit bureaus have no way of distinguishing between a short sale and a foreclosure.
So when a borrower who has worked with their lender to complete a short sale applies for another loan, a lender cannot tell from the credit report if they completed a short sale or went into foreclosure, and the hit to their credit is virtually the same. (In a short sale, a borrower sells the property for less than the amount owed on the mortgage and the lender accepts a discounted payoff.)
Many consumers, lenders and real estate agents involved in short sales are misinformed about the hit a borrower takes to their score.
"To the FICO score, there is very little difference between a short sale, a deed-in-lieu or a foreclosure — and we've been saying that to anybody who will listen, but this rumor that short sales are somehow benign has persisted," Watts said.
"How a default resolves itself, unfortunately for consumers, has very little predictive power and is not very relevant to the statistical likelihood that they would default in the future."
Some credit executives see a silver lining from the housing crisis.
Sarah Davies, a senior vice president of analytics at VantageScore Solutions, a Greenwich, Conn., firm that sells an alternative to FICO scores, said that only after the major credit bureaus have collected two years of performance data on loan modification will researchers be able to tell whether such borrowers behave differently.
"Credit scores are built with an understanding of a consumer's behavior and performance, and we're all watching to get insight into how loan mods will shape how consumers behave," Davies said. "It may be that there is no difference, in which case we won't change our algorithm."