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The Downside of Loan Modification

calculatorA few days ago, I got an email from my friend, a mortgage trader, pointing me to this article from Bloomberg News. The article lays out some scary facts – essentially, people who are undergoing mortgage loan modifications through the President’s Making Home Affordable plan are seeing their credit scores fall – and in some cases, fall hard. One of the folks featured in the piece says his score lost 121 points.

Why is this happening? That’s what I wanted to know. So I reached out to Craig Watts, my go-to source at Fair Isaac, the company that calculates the FICO score. The problem, Watts says, is that these loan modifications are fairly new, and there was some confusion about how lenders should report them to the three national credit bureaus. The calculation of your FICO score is an intricate process, and relies on a series of codes that are used to represent the actions you take that will affect your score. When you open a credit card, the lender reports that using a code. When you close a card, the lender uses a different code. These loan modifications, on the other hand, didn’t have a code yet. So the industry got together and decided to redefine an existing code, one that is also used to report a partial payment by a credit card borrower, an act that is seen as negative by the credit bureaus.

Still with me? In a nutshell, when your lender uses this code to report a mortgage modification, FICO – and other credit scoring systems – are factoring it into your score as a negative. Thus, your score drops. How far it drops actually depends on how high it was in the first place.

“it depends on what else is on the credit report, but it’s possible that a score could drop by 100 points. For someone who has a relatively high score, where this code could be the first big negative, this could cause the score to drop significantly. For someone who already has delinquencies, their score wouldn’t fall as far,” explains Watts.

The problem should be fixed in November. The industry has already agreed on a new code, but it takes some time to implement it across the board. Until that happens, there isn’t a whole lot consumers can do, unfortunately. Lenders have to report your loan modification, and as long as the information they report is accurate, and you agreed to the modified mortgage, you don’t have a place to challenge it. But here’s my advice – if you can’t make the payments, you’re already falling behind, and your score is likely already in trouble, I’d go forward with the modification. But if you’ve been keeping up with your payments so far, and you can hold out a few more months, you may want to weigh the possibility that your interest rates will go up against the fact that your credit score will go down.

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