Modify Your Loan? Watch Your Credit Score Drop

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The federal government is reporting that more than 60,000 U.S. homes have undergone successful home loan modifications in the past year. Maybe those homeowners realize it and maybe they don’t, but their credit scores will likely suffer.

Call it a "cause and effect" deal. Credit scores suffer not because of the actual loan modification, but from the delinquent payment practice that usually leads to loan modification.

Credit scores, calculated and published by Fair Isaacs (Stock Quote: FICO) under its "FICO" system, can range from 300 to 850 points. The negative impact of loan modifications can usually be measured by the number of mortgage payments that were late or missed completely.

The U.S. Treasury Department estimates that even homeowners who were current on their payment as they moved into a loan modification process can lose 100 points off their FICO score.

The mechanics of that loan modification work against homeowners and their credit scores. Once a bank or mortgage lender approves a trial modification, the standardized industry rules call for the lender to contact credit agencies and report the loan modification status, as well as the length and amount of any mortgage payment delinquencies.

The credit scoring “codes” that agencies assign to consumer credit reports let creditors know that the homeowner has entered into a loan modification agreement. Banks are loathe to go into detail on how much the coding impacts an individual’s credit score, but if the U.S. Treasury estimation is even close to the actual truth, then consumers can expect to see their credit scores decline by more than 100 points, especially if they’re delinquent on their loan obligations.

What’s the route back to good credit? When a consumer graduates from a trial modification to a permanent loan modification, credit scoring agencies record their mortgage loan status as "current." At that point, the prescriptions for climbing back up to a good credit score are time and a steady history of on-time credit payments.

There are some exceptions to the loan modification/credit score link. For example, your credit score won’t be negatively impacted if your lender moves you from a 15-year fixed mortgaged loan to a 30-year fixed mortgage loan. Additionally, any change in interest rates shouldn’t hurt your credit score either (by and large, loan interest rate changes aren’t reported to credit agencies).

But if you are or were delinquent on a mortgage loan, or have had your loan principal reduced, and have entered into a loan modification program, the die is cast and you’re likely to see your credit score fall off a cliff.

With loan modifications sticking to your credit report for 5-7 years, it could take a long time to repair the damage.

But presuming you make good on your new mortgage conditions, at least you’ll still have your house.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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