July 17 (Bloomberg) -- Victor Stern thought his money troubles were over when he got approval to modify his home loan. Then his credit score dropped 121 points.
Stern, a business development director at an information technology company in Charlotte, North Carolina, said he was shocked to see his credit score drop to 619 from 740 after entering the trial period for a loan adjustment under President Barack Obama’s Home Affordable Modification Program. A salary reduction caused him to seek a change in the terms of his loan before he missed any payments.
Banks, including Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp., report the loan modifications to credit bureaus. The adjustments can lower credit scores because of the way the FICO formula, the most widely used by U.S. lenders, works.
“There should be clear disclosures so consumers understand this is a major hit on the credit score,” said Evan Hendricks, Washington-based author of “Credit Scores & Credit Reports.” “There’s no sugar-coating the reality of the negative impact.”
The Home Affordable Modification Program began in March to reduce mortgage payments for those who are delinquent or in danger of defaulting. The lower-cost loans are subject to a three-month trial period, meaning data for the completed number of modifications under the program is still pending. Existing modification programs have not been very effective and have fallen short of goals, said Senator Richard Shelby, a Republican from Alabama, at a hearing on the housing programs in Washington yesterday.
Almost 2 million loans have been modified since 2007, according to the Hope Now coalition of servicers, investors and counselors in Washington.
Limit Modifications
Borrowers might decide against participating when they learn what the program can do to their credit scores, said Jack Guttentag, founder of the Web site mtgprofessor.com and professor of finance emeritus at the University of Pennsylvania’s Wharton School. That could limit the number of modifications and result in more foreclosures, Guttentag said.
More than 1.5 million properties received a default or auction notice or were seized by banks in the six months through June, RealtyTrac Inc. in Irvine, California, said yesterday in a statement. That’s a 15 percent increase from a year earlier.
Scores based on models established by Minneapolis-based FICO, formerly known as Fair Isaac Corp., are used to gauge a consumer’s financial health. The numbers, which range from 300 to 850, affect the ability to get mortgages, credit cards and insurance products, as well as the rates borrowers pay for them. A FICO score of 740 is generally needed for the best mortgage rates, according to Liz Pulliam Weston, author of “Your Credit Score.”
‘Behind Eight Ball’
“We view an account that has been settled or renegotiated for less than the full amount as a negative because historically consumers on reduced payment plans represent a greater risk,” said Ethan Dornhelm, a principal scientist at FICO’s San Rafael, California, office. The size of the impact may be more for borrowers with higher credit scores, he said.
“My FICO score and ability to get credit is in danger,” said Stern, 64. The limit on his credit card, which he relies on for business purposes, was slashed to $500 from $15,000. “This program is helping with payments on one side, but then hurting your credit on the other, so you wind up behind the eight ball.”
Stern declined to say which lender he used because he doesn’t want to jeopardize his reduced payment plan.
CDIA Rules
The Consumer Data Industry Association, which represents credit bureaus, has guidelines for lenders to follow when reporting loan adjustments. Mortgage investors Fannie Mae and Freddie Mac adhere to CDIA rules, which state that homeowners in the trial period should be reported as current and on partial payment plans if they are not delinquent with payments.
When homeowners fall at least 30 days behind on a mortgage payment, they should be listed as delinquent until the account is current, said Norm Magnuson, a spokesman for the Washington- based trade group. A new classification will be created in November that specifies a borrower received a loan modified under a federal government plan.
FICO may study whether penalizing borrowers for loan workouts is still valid as more changes are completed under the Obama administration’s housing plan, Dornhelm said.
Borrower’s Obligation
Lending institutions may offer their own loan workout programs that extend the life of the loan, lower the interest rate or reduce the principal amount owed and report those new terms in different ways to the credit-reporting firms, said Jesse Keenan, an adjunct professor of housing law and policy at the University of Miami School of Law.
St. Louis-based CitiMortgage and Bank of America in Charlotte, North Carolina, said they report loan modifications in compliance with CDIA guidelines. JPMorgan Chase, based in New York, follows the guidelines yet needs software updates to report the special condition, according to spokesman Tom Kelly.
“If you’re a lender, you want to know that a borrower had to have a loan modified to keep up with payments,” said Greg McBride, senior financial analyst at Bankrate.com, who is based in North Palm Beach, Florida. “It’s not unfair that a loan modification impacts a credit score since the borrower didn’t meet the original obligation.”
200-Point Dip
A loan modification won’t slash a credit score as much as a foreclosure will, according to Gerri Detweiler, a credit adviser for San Francisco-based Credit.com. A foreclosure stays on a credit report for seven years and may cause a dip of 200 points for borrowers with high credit scores, said Dornhelm of FICO.
Consumers who are considering loan workouts should know the exact terms of their agreements, including whether there is a permanent or temporary reduction in the monthly payments, said Barry Zigas, director of housing policy at the Consumer Federation of America in Washington.
They should also ask their lenders whether they are obtaining modifications through the government program or the bank’s proprietary program, and how the changes will be reported to the credit bureaus, Zigas said.
“Homeowners need to focus on the mountain, not the molehill,” said McBride, the Bankrate analyst. “They get to stay in their homes and can always try to repair their credit scores.”
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