This post originally appeared March 23, 2017 on CreditCards.com as “‘Deed in lieu: How it lowers your credit score, and what to do about it”
By Barry Paperno
Dear Speaking of Credit,
I’m going through a deed in lieu, which is soon to go through. My credit score is approximately 605, give or take. I have bad marks on my credit report due to no payments on my mortgage. How will the deed in lieu affect my credit score? And for how long? – Darrell
As the name implies, a deed in lieu of foreclosure (commonly known as deed in lieu) is an agreement that allows a homeowner to avoid foreclosure by voluntarily “deeding” – a fancy word for “turning” – over the property to the mortgage lender in return for being released from all obligations under the mortgage. The lender then sells the property to recoup the monetary loss, and the borrower is in the clear, both debt- and score-wise.
Any time a consumer can escape paying the full amount due on a debt of any kind, the usual consequence is serious damage to their credit score for years to come. You can expect to take an additional hit from your deed in lieu on top of the score drop already imposed by those missed mortgage payments. The same is true of the two other most common solutions to an unaffordable mortgage – foreclosures and short sales, in which the lender agrees to accept a payoff of less than the principal balance when the “underwater” home cannot be sold at price sufficient to pay off the remaining mortgage debt.
What determines the impact of a deed in lieu on a credit score
How low will your score go? And how long will it take to recover? The depths to which your score can be expected to sink further and its rebuilding timetable are going to depend heavily on two main points:
- How the loan balance is reported with the deed in lieu, and
- How the credit scoring calculations perform for you within the five scoring categories – payment history, amounts owed, length of credit history, new accounts and types of credit.
Let’s look at a couple of scenarios, determined by the final sales price of your property.
If all goes well with the property sale as part of the deed in lieu:
- Your lender will receive a price sufficient to cover the unpaid mortgage balance.
- The mortgage trade line on your credit report will then indicate that the lender has accepted a deed in lieu of foreclosure, and that your outstanding balance is $0.
If, by contrast, the property cannot be sold for what’s owed – in other words, if it’s “underwater” – and fails to bring a sales price that satisfies the debt, then you are facing a different scenario.
In this case, the sale might not bode so well for your credit score:
- On top of adding the deed in lieu indicator to the mortgage trade line, a “deficiency balance” for the unrecovered amount will appear as the outstanding loan balance.
- The consequences will be worse for your score than a $0 balance – with a higher dollar amount leading to a lower score.
A positive approach
While the scenario is far from great, here are two reasons to consider taking a positive view toward this otherwise bad situation:
- Since missed mortgage payments have already lowered your score to around 600, adding the deed in lieu may not lower your score by more than a few points – assuming there’s no deficiency balance and the rest of your credit looks good.
- If a deficiency balance is reported on your account, you can expect to lose up to another 25 points, depending on the amount of the balance remaining and, of course, your overall credit profile.
While losing another 25 points may not sound pretty, consider that someone with a high credit score just prior to the deed in lieu is likely to see it drop by more than 100 points. For you, on the other hand, the damage has already been done by those missed mortgage payments. Once the deed in lieu has been recorded along and all of the negativity associated with it is now in the rearview mirror, the passage of time can begin working on your behalf, and the recovery will begin.
Timetable for score recovery
Looking ahead, expect to spend the next three to five years re-establishing your credit before arriving at a respectable score in the 700s. If you plan to buy another home, this timetable should also work well for you, since most lenders require a 4-year wait following a deed in lieu, regardless of the score.
During this time, patiently managing your credit while allowing time to work its magic will help accelerate the score-building process.
Along the way, you can take the following proactive steps to improve your credit score:
- Make all payments on all open accounts in a timely manner each and every month.
- Ensure all open cards stay open by keeping them active with regular usage.
- Hold card debt down to a minimum. The ideal balance to carry is between 1 percent and 9 percent of your credit limits.
- If you have no open revolving accounts (credit cards) on your credit report, open a secured card – which require collateral for approval, usually a cash deposit with the issuing institution – to add some positive revolving history to your credit report and score.
- If, now that your mortgage has been closed, your credit report lacks an open installment loan, re-establish some positive installment credit history. You can do that by taking out a secured “credit-builder” personal installment loan.
In all cases, open new accounts sparingly and only when necessary.