Loan Modification - credit killer!

In Part One of our loan modification post, we discussed the fact that banks are sending unsolicited offers of loan modification to mortgage holders. These deals, which often involve a change from adjustable-rate mortgages (ARMs) to fixed-rates or partial “principal forgiveness” make a lot of sense from a purely economic standpoint: the banks get to clear their books of “toxic assets” and you get a lower mortgage payment. Unfortunately, the results can ding (or even wreck) your credit score.

There are a number of reasons why this is the case. First, the bank reports activity on your account to credit bureaus, which then alter your credit score accordingly. If you modify your loan and the bank submits “settled for less than the full amount due” to a credit bureau, that’s going to hurt you. And while this is technically true, a tiny line item leaves out the important information that it was, in fact, the bank that suggested the modification in the first place. To avoid this, make sure you ask specifically how the bank is going to report the change. If they don’t give you a straight answer right away, be clear that you’re trying to avoid “settled for less than the full amount due”.

Further, if the loan modification requires a trial period, especially one that lowers your mortgage payment, that trial period can damage your credit, as the bank will have to report the payment as less than what you owed, even though it’s the amount of money the bank is expecting, and will not respond to the customer as if anything were out of order.

The loan modification can also have tax repercussions, as any reduction in principal is treated as income by the IRS. If you’re already making a reasonable amount, an increase in taxes can be a real pain. In the worst case scenario, you may end up being unable to pay off this tax, and back taxes are (not surprisingly) a hit to your credit.

Thankfully, you have options. We’ve already said it, but again: ask your bank about the terms of your loan modification. Ask them how it will be reported to credit bureaus. Beyond that, you can avoid the tax problem through the Mortgage Forgiveness Debt Relief Act, which exempts you from taxes stemming from loan mods on your primary home. The act is good until 2012.

The bottom line? Always know what you’re getting into.

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