Mortgage loan modification and credit scores

Working on paperwork
  • Loan modifications stave off foreclosure, but damage credit.
  • Modification causes credit score damage that lasts for long time.
  • On-time payments can help reverse credit score damage.

Homeowners struggling to make their house payments may seek a mortgage loan modification in hopes of avoiding foreclosure and protecting their credit score. However, loan modifications also take a toll on those scores.

In theory, a loan modification should be a mutually acceptable solution to an out-of-control mortgage debt. The homeowner gets a workable payment schedule and the lender gets at least some of its loan repaid.

In practice, it's not that simple.

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How loan modifications hurt credit scores

Sometimes the credit damage in the mortgage modification process comes from a lack of coordination between the bank's loan mitigation department -- which works with mortgage holders to modify their loans -- and the foreclosure department.

For example, representatives in the bank's loan modification department often tell homeowners they must stop making mortgage payments before applying for a loan modification, says Rashmi Airan-Pace, a partner in the real estate law firm Airan2, Airan-Pace & Crosa in Coral Gables, Fla., whose practice is focused on assisting homeowners in distress.

James Spray, a mortgage banker and credit expert at America's Mortgage in Denver, agrees that loan modification departments frequently urge customers to skip payments.

"If you don't miss any payments, you're not showing that you're bleeding," Spray says.

But as soon as homeowners skip a payment, the bank's foreclosure department reports the missed payment to the credit reporting agencies. As a result, the borrower's credit score takes a hit -- not just once, but again each month a new payment is missed.

"This will continue until the loan is paid off," Spray says.

Even if the loan mitigation department and the foreclosure department work together, it won't be enough to completely spare the borrower's credit from damage. Spray says even a successful loan modification will continue to pull down the credit score every month because "the original contract, in which you promised to pay a certain amount, has been breached."

While a loan modification doesn't end up as a legal action, such as foreclosure or bankruptcy, on the credit report, it's still "a pretty heavy hit. Your payment history is about 35 percent of your credit score," Spray says.

Options to improve your score

If a loan modification has damaged your credit, there are ways to shore up your credit score. But you'll need a professional's help.

"The consumer is pretty helpless here," Spray says. "Other than disputing items that are false, there's nothing they can do by themselves."

Negative items can't be erased, but sometimes a credit score can be improved by having positive information such as on-time payments entered on the credit report, Melinda Opperman, a senior vice president at Springboard Nonprofit Consumer Credit Management in Riverside, Calif.

This has to be done through the mortgage lender, which contacts a company specializing in rapid rescoring that works directly with credit reporting agencies.

"But it's not easy or cheap," Spray says. "Depending on the number of trade-line items that need to be fixed, it could be anywhere from $150 to $1,200."

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