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.
Although bankruptcy is the worst single thing you can do to your credit scores, foreclosure is right up there among the big baddies. The credit-scoring code that indicates foreclosure or deed in lieu of foreclosure (whereby you turn the keys over to the bank rather than try to fight) is a "serious derogatory," said Craig Watts, a spokesman for Fair Isaac, the creators of the FICO credit-scoring system.
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."
BankruptcyTypically, consumers file for Chapter 7 bankruptcy protection, which erases most unsecured debts, such as credit card charges and medical bills. A Chapter 7 bankruptcy can remain on your credit reports for 10 years from the date your case was filed.
A Chapter 13 bankruptcy, by contrast, is usually reported by the credit bureaus for only seven years from the filing date. But Chapter 13 cases require a repayment plan that can take five years to complete. (Once you've finished the repayment plan, your still-unpaid unsecured debt is typically erased).
While you're in a repayment plan, you're usually a tough sell to other lenders, who are likely to shun you until your case has been discharged.
That's why Chapter 7 bankruptcies are often touted as a better solution for consumers: Much, if not all, of their debt is erased, and they get a fresh start that allows them to begin rebuilding their credit right away.
In fact, before the credit crunch, consumers who filed under Chapter 7 could expect to be flooded with offers for high-rate credit cards even before their cases were discharged. Some could get mortgage loans within six months.
The crunch has pretty much done away with that easy credit, but bankruptcy still is not a permanent black mark. People who get their finances in order and take steps to boost their credit scores can get their credit back to near-prime levels within a few years. My column "Bounce back fast after bankruptcy" outlines some important credit-building tips:
- Get your finances right, which means living within your means and building up an emergency fund.
- Scour your credit reports for errors, including accounts that were included in the bankruptcy but aren't listed that way on your reports.
- Pay your bills on time, all the time.
- Get and use a secured line of credit, paying off your balances in full and never using more than 30% of your available credit limit.
- Consider getting an installment loan.
For more on bankruptcy, check out MSN Money's bankruptcy guide.
DivorceForeclosure and bankruptcy can be expensive, but few setbacks destroy wealth quite like a divorce.
It's not just that all your assets are divided or that the same income has to support two households now instead of one.
There's something about divorce that sets you back even further than if you'd never been married.
In a recent 15-year study of 9,000 people, those who married and stayed married built up nearly twice the net worth of single folks. (I mentioned this study in a recent column, "Get real: Marriage is a business.")But people who married and then divorced saw their net worths plunge far below that of single folks. The divorced folks' average net worth was 77% lower than that of single people, and the drop in wealth began four years before the divorce was final.
The divorced people in the study did begin to rebuild after the divorce, but their progress was slow. Ten years after divorce, their median net worth was $10,000, while the still-married couples built up a median net worth of $43,000 after 10 years.
Clearly, money you spend trying to avoid divorce -- for example, on counseling -- could be a good investment. If there's no hope, mediation and other efforts to minimize legal fees can help slow down the wealth burn rate. Other ideas:
- Bone up. Read "How to leave your husband" and "How to leave your wife" for the financial steps you should take before a divorce.
- Pay for good legal advice. Don't cheat yourself in your rush out the door. Although you want to avoid an expensive legal fight, knowing your rights can help you get the most equitable settlement.
- Separate your credit before the divorce is final. Read "Don't let your ex trash your credit" to understand why you don't want any joint credit obligations with your ex. It doesn't matter who is responsible for paying according to the divorce decree. If your name is on the debt, it affects your credit.
- Make wealth creation a priority. You may still be paying off your legal bills, and your living expenses may have soared. But you still need to be concerned about your future. Make every effort possible to live below your means, build up a savings cushion (read "Why you need $500 in the bank") and invest for retirement.
Liz Pulliam Weston's latest book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.
Published Aug. 28, 2008