This article examines the credit score impact of a short sale versus a foreclosure, and advises a strategic default as financially advantageous for California’s negative equity homeowners.
Credit scores: Not the decisive factor
Underwater homeowners may now look for other reasons to decide between a short sale and foreclosure. Both events equally impact their Fair Isaac Company (FICO) score, finds a recent FICO study of mortgage delinquency data from the three credit bureaus.
On either closing a short sale or defaulting and losing the home by foreclosure, an underwater (or negative equity) homeowner whose starting credit score was 620 saw it drop to a range of 575-595. Underwater homeowners with a mid-tier starting score of 720 saw it drop to 570-590; high-tier starting scores of 780 dropped to 620-640.
Thus, no distinction is made in FICO ratings between getting rid of an underwater home by short sale versus losing it to foreclosure. [For more information on the FICO study’s data regarding the effect of short sales versus foreclosures on credit scores, see Housing Wire article, Short sales and foreclosures equally degrade FICO scores.]
Further, scores have the same estimated recovery time after both short sales and foreclosures. Starting scores of 680 are estimated to take three years to recover after either a short sale or foreclosure, and both mid-tier scores of 720 and high-tier scores of 780 are estimated to take seven years to fully recover.
By either disposal method of the underwater home, the owner needs to do a little prior planning for his future credit needs and arrange his finances accordingly before he defaults (which is required to initiate both short sales and foreclosure).
Default to walk away: When to exercise sense and rights
The belief a foreclosure is far more damaging to credit scores than a short sale is a common myth held by real estate agents. The myth has come about since credit scoring methods are at best elusive and always confusing from the consumer’s vantage point – and most authorities will do nothing to clarify them.
So when an underwater homeowner is faced with choosing between a short sale and foreclosure, his real estate broker or agent needs to advise him that, FICO-wise, the results are the same. Armed with the facts, the homeowner is able to weigh other financial aspects when ridding himself of his underwater home by either negotiating a discount (short sale payoff) or walking away and letting the home go to foreclosure (strategic default). [For more information on FICO scores, see the June 2010 first tuesday article, The FICO score delusion.]
Thus, for brokers and agents working with a negative equity homeowner: any advice which says a short sale payoff will have a less detrimental effect on a credit score than a strategic default is a pure misrepresentation of the facts. Further, it is the contractual right of California’s underwater homeowners to strategically default, an exercise of the put option built into trust deeds and protected by anti-deficiency rules.
It is most advantageous for the underwater homeowner to strategically default when his loan-to-value (LTV) ratio is 162% or more, as reported by a Federal Reserve Board study. Here at first tuesday we advocate a 125% LTV ratio as the most judicious point at which a negative equity homeowner should consider a default. No modification programs are available for owners beyond that point and prices are not going to return to justify those loan amounts until well into the next decade. [For more information on LTV ratios, see the October 2010 first tuesday article, The LTV tipping point: when negative equity owners strategically default.]
In a nonrecourse state like California, lenders forego the right to pursue a deficiency judgment against homeowners who default on purchase-assist or refinance loans encumbering their underwater homes. Thus, California homeowners simply exercise the put option contained in every trust deed which grants a homeowner the right to walk away and force the lender to purchase the underwater home for the loan balance and costs.
The homeowner’s initial promise to pay contained in the original note for the purchase-assist or refinance loan is unenforceable, and the lender has no legal right to collect beyond a foreclosure. [For more information on the homeowner’s right to strategically default in California, see the November 2009 first tuesday article, California homeowners exercising your right to default.]
To strategically default is simply sensible for a negative equity homeowner – he need not make any further mortgage payments. Further, and financially most important, he is able to save the payments during the approximate 12-month period from first default to the foreclosure sale and continue to occupy the property until the date of the foreclosure sale without further payment. He can then later use the savings to immediately make a 20% down payment on an equivalent home at around half the old loan amount and half the old payment, if he is so inclined.
An underwater home is a black-hole asset which eats up excessive mortgage payments and significantly lowers the owner’s standard of living. Only the lender benefits when an underwater homeowner continues to make mortgage payments, until the loan is reduced to 94% of the home’s value. The homeowner’s responsible exit strategy in this case includes electing to strategically default, a necessary dose of prudent planning to get his upside-down finances right-side up. [For more information on financial planning for negative equity homeowners, see the March 2010 first tuesday article, The underwater homeowner, his future and his agent: a balance sheet reality check.]