We all know people who have emerged from serious financial setbacks with smiles on their faces and songs in their hearts. Whether beset by bankruptcy, foreclosure or divorce, these folks insist they're so much better off now than they were pre-disaster.
And, emotionally, perhaps they are. The effects on their finances, though, are likely to linger.
Serious financial setbacks do more than send your blood pressure soaring. They can destroy wealth and wreak havoc on your credit.
That doesn't mean, however, that the effects have to be permanent. Knowing what's in store can help you offset some of the damage.
Here are three common setbacks and how they'll affect your finances:
ForeclosureExpect the whole foreclosure process to beat your credit scores, the three-digit numbers lenders use to gauge your creditworthiness, to a bloody pulp.
- Round 1: The damage starts the first time you miss a payment. One skipped payment can knock as much as 100 points off a credit score. Every subsequent late or missed payment increases the injury to your scores.
- Round 2: Another blow will land when your lender files a "notice of default" at the county courthouse, which is the signal that foreclosure proceedings have begun. That notice will show up in the public-records section of your credit reports, the same place where other bad things such as bankruptcy filings and lawsuit judgments appear.
- Round 3: The knockout punch will be when the foreclosure is final and the lender reports it to the credit bureaus.
What if you avoid a foreclosure through a short sale, in which the lender agrees to accept the proceeds of a sale as full payment of the mortgage? That all depends, Watts said, on how the lender reports the transaction to the credit bureaus.
The FICO scoring system doesn't have a code that indicates a short sale, so many lenders use a code denoting that your loan was "settled," or paid off for less than what you owed. (See "Use a short sale to escape foreclosure.")
Such settlements, Watts said, are also considered serious derogatories. Any difference in the toll on your credit scores from a foreclosure or a short sale is likely to be academic. Either way, your scores will be in the basement.
You might be able to dodge this last bullet if you can talk the lender into reporting the loan "paid as agreed," but don't hold your breath. Just getting a lender to accept a short sale can be accomplishment enough. Trying to get the lender to cut you another break, on top of accepting less than you owe, might be too much to expect.So how long can you expect the credit damage to last?
Technically, the black marks will remain on your credit reports for seven years. But if you take steps to improve your credit (see "7 fast fixes for your credit score"), you may not have to stay in the penalty box for that long.
Here's what to expect:
- You'll be on a three-year blacklist for Federal Housing Administration loans. You typically won't be able to get a mortgage insured by the FHA for three years, real-estate expert Elizabeth Razzi said, "unless you can show lenders there were extenuating circumstances, such as the illness of the household's primary wage earner, that caused you to lose your home."
- Your mileage may vary with other lenders. How long it will take other lenders to forgive you depends on how long the current credit crunch lasts. Right now, lenders spooked by huge losses are demanding bigger down payments and higher credit scores for most types of lending, and few are willing to take a chance on people with recent foreclosures. That could change. "With so many foreclosures happening now, there will be a big pool of people with these big blemishes on their credit histories," said Razzi, a Washington Post columnist and the author of "The Fearless Home Buyer: Razzi's Rules for Staying in Control of the Deal." "After credit markets regain their health, you may find lenders a little more tolerant of these credit-history blemishes than they were in the past."
- The better your scores, the better your prospects. Credit expert John Ulzheimer agrees that mortgage lenders in the future may well distinguish between "somebody who chose not to pay their bills and someone who has great credit but got into a loan that wasn't a good fit."
But people who have been through foreclosure should still put every effort into raising their credit scores afterward, both experts said.
A foreclosure "won't ever be completely ignored while it's on a credit report," said Ulzheimer, who contributes to Credit.com and appears on CNBC's "On the Money," "because an underwriter has to depend on a credit score and isn't equipped with the knowledge needed to speculate as to what the score would be without the foreclosure."