Will a Loan Modification Affect My Credit Score?

by tammy on March 12, 2010

In a word, yes: most loan modification agreements will have a negative impact on your credit scores. Though this issue is being hotly debated and there appears to be a consumer advocacy movement against this, the fact of the matter is that if your lender notifies the credit bureaus of a loan modification agreement, it will be counted as a negative item on your credit report and will lower your credit scores. All three of the major credit reporting agencies – Equifax, Experian, and TransUnion – are reporting loan modification agreements as “partial payment plans” which negatively affect your credit.

The industry argument is that loan modification almost always results in the lender accepting a less profitable arrangement than the original one agreed to, regardless of whether or not any of the principal forgiven or the interest rates is reduced. Further, the credit reporting agencies accurately point out that most lenders do not accept loan modification agreements unless the borrower is already facing extreme difficulty meeting the terms of the original agreement. This, in turn, means that anyone that the lenders are willing to offer loan modification to really is a significant credit risk. While these arguments are sympathetic, they are rational and make sense, which means it seems unlikely that this reporting procedure will come to an end.

The consumer advocacy argument against this reporting procedure stems from the fact that in most loan modification agreements, neither the principal nor the interest is lowered, so every penny owed remains due. They equate mortgage loan modification to a lenders that temporary defer full repayment of other types of loans due to some extraordinary circumstance, a measure that usually does not have a negative impact on the borrower’s credit score. The underlying rationale is sound which has led to heated debate and discussion in some of the financial media like Bloomberg and Credit.com.

Further, the negative reporting is even worse if the borrower qualifies, and applies, for loan modification under the government sponsored Making Home Affordable (MHA) program. One of the stipulations of the MHA program is that the borrower has to make three timely trial payments before the loan is officially modified. These trial payments are at a lower rate than the terms of the standing loan terms, which means that throughout this period the borrower carries a rolling delinquency until the loan is officially modified. This is reported on the borrower’s credit report as a three month delinquency and can have severe consequences to the borrower’s credit score. Then, once the loan is officially modified, this too is reported to the credit bureaus as the “partial payment plan” described above, further lowering the credit scores.

The one way to avoid this is if the borrower specifically asks the lender not to report the loan modification to the credit bureaus and the lender willingly agrees. If the borrower has a good relationship with the lender and lender wants to keep their business despite the loan modification, the lender may agree to this, though they are not required to do so. After all, there is no harm in asking for this favor regardless as the default will be the negative reporting.

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