You purchased the property when real estate values were good. Now they’ve dropped below the debt on the property and the equity is gone. You’ve concluded it doesn’t make sense to keep the property and are considering a short sale. You know the bank (or banks if you have more than one mortgage on the property) will likely agree on the arrangement. You’ve spoken to your tax and legal advisors to make sure the short sale is handled properly. Now the remaining question is what impact will the short sale have on your credit score in the future?
The short answer is that your score will drop about 100-150 points due to the missed payments and possibly another 75 to 100 points due to the “derogatory event” on your credit. However, once the sale is completed, and there’s no more debt or missed payments, your score itself will begin climbing and likely be recovered in 18-24 months. In some cases lenders will still disqualify you as a lending risk for up to 36 months.
So how does this all come together? Let’s start with how credit “scoring” works. Just about every adult in the United States has a “File” with the three major Credit Bureaus (TransUnion, EquiFax, and Experian) that includes the information reported by creditors on that person for all the credit transactions they’ve been a part of and any other public records which involved credit (things like judgments, liens, IRS levy’s, bankruptcy filings, foreclosures, etc.). Along with each “record” in your File is some indication of your performance on the credit item. For example, if the entry is a debt of some kind (home mortgage, auto loan, etc.) then there will be a reflection of payment performance and some statement of current status. The payment performance is simply whether or not the payment was made on time or late. The status will usually be something like “paid as agreed” or “not paid as agreed.” This is your credit “History” and is used as the raw data to calculate your credit “Score.”
Your Credit Score is a statistically derived estimate of your credit worthiness and is used by lenders to determine the risk of lending in any particular situation. The actual math behind the score is considered a trade secret by the Credit Bureaus and is changed regularly, the most recent change occurred in 2009. But the basics of the scoring have seen wide-spread publication.
There are essentially four parts to the score with each part contributing a portion to the overall score. Think of it as similar to the way grades were determined in school where the teacher allocated 30% to tests, 30% to assignments, 20% to projects and 20% to attendance and participation. While not exact, the four parts of the credit score and their weights are approximately as follows:
1. Payment History (30%) – this portion of the score measures whether or not payments are made on time. Typically, if a payment is made within 30 days of the due date it is considered “on time” and after that, it’s considered “late.” The more recent the “late” payment, the heavier the penalty. So a string of late or missed payments a year ago will have much less impact than a string of recent missed payments.
2. Use of Available Credit (30%) – This part of the score attempts to measure how credit is used. If all of the available credit has been used, the score will be lower. If there’s a substantial amount of available credit then the score will be higher. So for example, if you have a credit card with a $10,000 credit limit and the balance is $9,500 your credit score will decrease. However, if the credit balance is $1,000 then your credit score will increase. A low balance compared to the available limit helps your score and the opposite hurts it.
3. Derogatory Events (30%) – These are the items listed in your credit history that reflect negative events. Things like charge-offs, foreclosures, bankruptcy, etc. Each type of negative event is assigned a weight and the older the event is, the less it counts against you.
4. Miscellaneous Items (10%) – These are various other items and calculations that factor into the credit score.
Keep in mind that these are general categories and the percentages are approximates. The exact formula for the credit score is constantly changing and kept secret by the credit bureaus. However, these provide a good framework for understanding how a short sale will impact your score.
A short sale impacts your score in three areas.
1. Payment History – In order to be considered for a short sale, the bank will require a delinquency. That means you have to miss payments and when you miss payments, these will negatively impact your credit score. However, there are only about 150 to 180 points possible for payments. Once you’ve missed 6-8 payments, you’ve lost all the points possible in this category. After the sale’s completed (so long as it’s done properly), the debt is gone so there are no more payments to make, therefore no more payments to miss. So as time passes, the missed payments get older and older and their weight in pulling down your score gets less and less. After 12-18 months the impact of the missed payments has washed out of the scoring model to the point that it no longer has a negative impact. If you’ve been making payments on other debts (such as an auto loan or other mortgage) during the 12-18 month period, these positive events will eventually outweigh the negative payments to the point that your score may have recovered to its original level.
2. Use of Available Credit – Mortgages are typically some of the larger debts in your history and often, the amount of principal that has been paid is small. If your loan was a negative amortization loan then the principal balance wouldn’t have decreased at all. In any event, the majority of the available balance (original principal amount) will still be outstanding. This means most of the available debt in your file will likely be “used” which decreases your score. However, once the sale occurs (again, so long as it’s done correctly) the debt will be gone and the “used” portion of the debt will also be gone so in most cases this will also help your score.
3. Derogatory History – Once the sale is complete, the lender will likely report that the debt was “settled for less than the full amount” or something along those lines. This will be considered a derogatory event on your credit and will usually remain on the history for 7 years. However, the good news is that most lenders won’t consider this “negative” event longer than 24 to 36 months after the sale. In some cases this may be as short as 12-18 months.
So when you begin the process of a short sale, plan on watching your score drop quite a ways. But make sure the sale’s done properly and 12-18 months after the sale, your score will likely be as good as it was before this all happened. And 24-36 months after the sale, lenders won’t even be concerned about the short sale.