Editor’s note: The loss of homes, jobs and wealth, coupled with an environment of tighter lending, has barred some consumers from owning a home again for at least several years. This article, Part 1 of a "Rebuilding Homeownership" series, explores the scope of bankruptcies and foreclosures and the impact to would-be homeowners. Part 2 explores the assistance that real estate agents can offer in helping consumers get back on firm financial footing, and Part 3 explores whether lenders will make allowances for borrowers with checkered credit histories.
Long after the global financial crisis subsides and the U.S. economy is again creating jobs, many former homeowners may find it hard to convince lenders to give them the time of day.
Bankruptcies and foreclosures are leaving lasting scars on millions of borrowers’ credit reports, and many will be unable to obtain a mortgage for years to come. Even those who hang onto their homes are seeing their credit dinged after missing payments on their mortgage, car loan, or credit cards.
A heavy toll
According to data gathered by the HOPE NOW alliance of loan servicers, lenders started foreclosure proceedings on about 6.1 million homes from July 2007 through the end of 2009. During that time, loan servicers completed 2.2 million foreclosure sales (figures for the final month of 2009 are estimated).
Loan servicers initiated about 7.3 million workouts with troubled borrowers during the same period, including 4 million repayment plans and 3.25 million loan modifications. Statistically, many of those borrowers are likely to have redefaulted, and even those who were "cured" may still have taken a hit on their credit scores.
Data provider First American CoreLogic reported that as of September, 11.3 million homeowners were "underwater" — they owed more on their mortgage than their homes were worth — making it difficult for them to sell their property or refinance it.
Personal bankruptcy filings — which plummeted after stricter requirements were put in place in 2005 — have climbed back up through the 1-million-per-year mark. The 1.4 million personal bankruptcy filings received by U.S. courts last year was more than double the number seen in 2006, when laws that raised the bar for filing for bankruptcy took effect.
Bankruptcy filings tend to be particularly damaging to a borrower’s credit, since they often involve defaults on more than one debt — a mortgage, car loan, and credit card accounts, for example — and stay on a borrower’s credit report for seven to 10 years.
Unemployment continues to weigh heavily on consumers, too. According to the U.S. Department of Labor, 14.8 million Americans were out of work in January, or 9.7 percent of the workforce. The ranks of the long-term unemployed — those out of week for 27 weeks or more — swelled to 6.3 million, up 5 million since the beginning of the recession in December 2007.
Housing market’s mixed signals
The U.S. financial crisis is proving to be a complex beast — still triggering aftershocks throughout the global economy. And the housing market’s vital signs are a mixed bag.
According to the most recent numbers from the U.S. Census Bureau, the homeownership rate fell to 67.2 percent at the end of 2009 — about where it was at the tail end of the dot-com boom.
Builders have slammed the brakes on new-home construction, but in many markets the supply of homes far exceeds the number of ready, willing and able buyers. Not only are builders still working to clear the remaining inventory they constructed during the boom, but the combination of falling home prices and rising unemployment is sending homes into foreclosure by the millions, which keeps pressure on inventories.
On the buy side of the equation, there’s pent-up demand for homes as would-be buyers look for signs that prices are stabilizing. Investors and first-time homebuyers with secure jobs and good credit are moving to snatch up bargains.
But unemployment and uncertainty about the economy continue to limit demand. More ominously, perhaps, lenders have tightened underwriting standards and raised downpayment requirements to the point that many who would like to take advantage of more affordable home prices and low interest rates cannot. …CONTINUED
Credit-score collapse
An individual’s credit score, which is key in securing a home loan, can take a huge hit from a foreclosure or personal bankruptcy.
A "surprise bankruptcy" — one filed by a borrower with an otherwise good credit record — can knock 200 or more points off the FICO score of a borrower with a score in the high 700s, said Craig Watts, a spokesman for Fair Isaac Corp. The impact for a borrower with a lower score is likely to be less dramatic, because their score has already been battered by other issues, Watts said.
According to a "Credit Q&A" Fair Isaac has posted at its consumer facing site, myFICO.com, a hypothetical borrower with an unblemished 15-year credit history can expect to see their near perfect FICO score of 780 plummet to somewhere between 540 and 560 if they declare bankruptcy. That’s a "subprime" score assigned to borrowers most mortgage lenders currently consider too risky (the FICO score has a range of 300 to 850).
A foreclosure would take the same borrower’s score into the 620-640 range — just above subprime — requiring a larger down payment on a mortgage that will also carry a higher interest rate.
According to a loan calculator at myFico.com, a borrower with a FICO score in the 620 to 639 range can currently expect to pay about 6.3 percent interest on a conventional, conforming loan with a 20 percent down payment, compared to 5 percent or less for borrowers with scores of 680 or better.
On a $200,000 loan, that translates into a monthly payment of $1,237, compared to $1,085 or less for borrowers on the upper end of the scale. Over the life of the loan, a borrower with a score of 620-639 would pay $72,000 more interest than a borrower with a FICO score of 760 or higher. Just bumping their score up into the 660-679 range would save $125 a month, or $44,880 over the life of the loan.
Settling a credit card debt — an event similar to engaging in a workout with a mortgage lender — would push a 780 FICO score into the 655-675 range, the Q&A posted to myFICO.com said.
A bankruptcy, foreclosure, or settling a credit card debt would push the FICO score of a hypothetical borrower with an eight-year credit history and only two previous delinquencies down from 680 into the subprime range. That borrower could expect a bankruptcy to leave them with a FICO score of 530 to 550, while foreclosure would result in a 575 to 595 range.
Watts said borrowers in such predicaments shouldn’t expect to see much improvement in their FICO score for at least two years.
"Your credit reputation tends to rebuilt slowly," Watts said. "The general guidelines are that within a couple of years of one of these serious events, your score will begin to recover — assuming you have established a record of responsible credit management, and are paying your bills on time."
Other factors
Of course, credit scores are only one of many factors that lenders weigh in deciding whether to fund a loan. Lenders are more willing to approve loans when borrowers have sizeable downpayments that reduce the loan-to-value ratio. A reasonable debt-to-income ratio indicates that a borrower won’t have to stretch to make their monthly payments.
"The FICO score is still an important component, but I wouldn’t give it the same weight as before," said Alan Riegler, a banking industry consultant with Phoenix-based CCG Catalyst.
As home prices stabilize and secondary markets that funnel investment dollars into mortgage lending recover, what will be most important to lenders is gaining a true understanding of a borrower’s ability to pay, Riegler said.
While bankruptcies and foreclosures will impact the size of the pool of eligible borrowers, Rielger thinks unemployment and increased downpayment requirements will be larger factors in limiting demand.
"When they are ready to reenter (the housing market), they will have to meet certain hurdles, including having a down payment and demonstrating their ability to repay a loan," Riegler said. "First a job, then the downpayment — that is what will keep people out of the market."
Keeping score
Fair Isaac builds mathematical formulas that are used to evaluate borrowers’ creditworthiness by plugging in historical information collected by the three major credit reporting agencies: TransUnion, Experian and Equifax.
The formulas don’t distinguish a bankruptcy from a foreclosure, per se — they are all regarded as "serious delinquencies" in which a debtor has no prospect of meeting an obligation, Watts said.
Short sales and deeds in lieu of foreclosure fall into the same class when reported as mortgage defaults to credit reporting agencies. …CONTINUED
With short sales and deeds in lieu, it’s often hard for the scoring model to tell exactly what the lender has done, because of the different options credit reporting agencies give lenders for reporting such events, Watts said. But if short sales and deeds in lieu of foreclosure are reported as some form of mortgage default, they are treated accordingly.
"They are in the same class as any (event) where the consumer has defaulted," Watts said. "If you consider what the FICO score is trying to predict, they are highly predictive of future risk of default."
With the collapse of the secondary market for "private label" mortgage-backed securities in 2007, nearly all mortgages being made today are purchased or guaranteed by Fannie Mae, Freddie Mac, or the Federal Housing Administration (FHA).
As a general rule, Fannie Mae will not purchase or guarantee loans if the borrower has a FICO score under 620, "regardless of the documented circumstances or offsetting contributory risk factors from the underwriter’s comprehensive risk assessment."
Fannie Mae will allow some borrowers with little or no credit history to obtain loans that are manually underwritten using "nontraditional" measures of credit worthiness, such as utility bills, in lieu of a FICO score.
In January, the Federal Housing Administration said it would begin requiring a minimum FICO score of 580 for borrowers making down payments of less than 10 percent (see story). Lenders making loans with FHA mortgage insurance often have stricter requirements.
Fannie Mae won’t even consider a borrower who has been through a bankruptcy in the past two years.
Consumers who discharge their debt through a Chapter 7 liquidation must generally wait for four years after closure of the bankruptcy proceeding before Fannie Mae will consider guaranteeing their home loan. The waiting period can be as short as two years if "extenuating circumstances" beyond the borrower’s control, such as the loss of a job, illness or divorce, can be demonstrated.
Borrowers who have successfully completed a Chapter 13 bankruptcy filing, paying off their unsecured creditors in part or in full, can be back in Fannie Mae’s good graces within two years of having their cases discharged. If they are unable to complete their Chapter 13 plan, they will be ineligible for a Fannie Mae-guaranteed mortgage for four years after their case is dismissed from bankruptcy court.
Fannie Mae generally requires five years for borrowers to re-establish credit after filing for foreclosure, but they may qualify in as soon as three years if they can document extenuating circumstances.
Either way, once a borrower who has been through a foreclosure is deemed eligible to take out a Fannie Mae-backed loan, they will still face tougher underwriting requirements than borrowers who have not.
Borrowers who have been foreclosed on within the last seven years must have a minimum FICO score of 680 and make a minimum 10 percent downpayment to qualify for a Fannie Mae-backed loan.
The minimum down payment for borrowers with no foreclosure in the past seven years and a FICO score of 660 or better is 5 percent. Borrowers who have not been foreclosed on in the last seven years may qualify for a Fannie Mae-backed loan with a FICO score as low as 620 if their loan-to-value ratio is 75 percent or less.
For FHA loans, a foreclosure or deed-in-lieu will generally leave borrowers ineligible for three years, barring extenuating circumstances that include the serious illness or death of a wage earner. Extenuating circumstances do not include an inability to sell a home because of a job transfer or relocation.
Borrowers who have entered into Chapter 13 bankruptcy repayment plans may be able to obtain an FHA-insured mortgage once they have made all required payments during the first year of the plan, and they receive permission from the bankruptcy court to enter into a mortgage.
FHA usually requires two years to re-establish credit after a Chapter 7 liquidation, but may consider borrowers in as little as one year if they can demonstrate they faced extenuating circumstances beyond their control and have since proved their ability to manage their financial affairs.
Having a short sale in one’s past is not necessarily an obstacle to obtaining an FHA loan, as long as the borrower was current on their mortgage when the sale occurred. Otherwise, there’s a 3-year waiting period.
Similarly, Fannie Mae won’t back a loan for a borrower who’s been involved in a "preforeclosure sale" — a short sale that takes place after the borrower defaults and the lender starts the foreclosure process — in the past two years. There are no exceptions for extenuating circumstances.
Loan modifications
The picture for homeowners who have missed mortgage payments or negotiated a workout with their lender is less dire, according to a recent white paper published by VantageScore, a scoring system established as a rival to FICO by TransUnion, Experian and Equifax. …CONTINUED
According to the VantageScore white paper, even borrowers who have multiple loan delinquencies before obtaining a loan modification or repayment plan can undo much of the damage to their VantageScore within nine months of bringing all loans current.
Borrowers who only bring their mortgage current but remain delinquent on other debts will still be in subprime territory two years after entering into a loan modification, VantageScore warned.
One takeaway: loan modifications should be structured to allow borrowers with enough cash flow to bring other debts current as quickly as possible.
Borrowers who are granted forbearance before entering into a loan modification won’t see a reduction in their VantageScore if they continue to make the reduced payments.
A loan modification involving forgiveness of principal can actually raise the borrower’s score, by reducing their debt utilization level. If a loan modification results in the creation of a new account, however, that will reduce the average age of debts on the borrower’s file and dent their score, VantageScore said.
Watts said borrowers who receive loan modifications under the Obama administration’s Home Affordable Modification Program (HAMP) won’t see an impact in their FICO score if lenders use the specific code indicating a HAMP modification when reporting the event to credit bureaus.
Once Fair Isaac has more data on how HAMP loan modifications are performing, that information could be built into the formula used to calculate the FICO score, he said.
Borrowers who are in loan modifications may still be eligible for an FHA-backed loan as long as their lenders are not reporting them as delinquent. A HUD spokesman said lenders generally report borrowers who are in temporary HAMP loan modifications as delinquent.
Similarly, Fannie Mae warns lenders that borrowers must be current on their existing mortgages at the time they apply for a new loan.
Assessing the damage
So how much damage has the downturn done to borrowers’ credit scores?
Before the downturn was in full swing, myFICO.com published a chart showing the distribution of FICO scores across the U.S. population, based on data obtained from all three credit reporting agencies. The chart showed only 15 percent of those with credit histories scoring below 600, and 58 percent scoring 700 or better.
Watts said that while the distribution curve has changed somewhat since then, the median FICO score has changed very little during the past four years. Based on data from Equifax, Watts said, half of borrowers have FICO scores of 713 or better.
"The untold story of this recession is the improvement in credit scores for millions of consumers who cut back on their use of credit, postponed purchases that would have required credit for financing, and paid down their credit card debt," Watts said.
"Where the national median FICO score is concerned, that positive score movement has counterbalanced the downward movement of millions of other, better-publicized consumers who ran into financial difficulties."
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