Short Sales and Credit Scores: Questions from Mint.com Facebook Fans

John Ulzheimer, a MintLife personal finance expert, is answering questions straight from fans of the Mint.com Facebook page. Here’s what he has to say about short sales and credit scores:

Q1: How exactly does short selling your home impact your credit and for how long?

A short sale is a more recently popular way to dispose of an underwater mortgage, which is a mortgage where you owe more than the home is worth. According to some sources, about 30% of mortgages are currently in this situation, including the mortgage belonging to yours truly, a humbled credit expert.

A short sale occurs when a buyer makes an offer on your home but that offer doesn’t cover the amount of loans taken against the house. So, if you owe $250,000 but are offered only $200,000, then you’ve been made a short offer. If your lender agrees to accept the offer to dispose of the home, then the home has been sold short. The good news is you’re out of the loan and don’t owe that $50,000 deficiency balance.

The news isn’t all good. Short sales are reported to the credit reporting agencies as a settlement, which is an accurate depiction of the loan. The lender settled for less than your really owe, hence the settlement credit reporting. And, yes, settlements are considered to be derogatory by credit scoring systems.

Don’t believe the marketing by real estate agents that short sales are better for your credit than foreclosures. That’s not true. Settlements will remain on your credit reports as long as foreclosures do and they have the same impact to your credit scores. The only difference is if the lender doesn’t report the deficiency balance along with your settlement. If that’s the case, then the impact to your credit scores isn’t quite as bad as a foreclosure.

Q2: Why does not paying our bills drop our credit, but paying them does nothing? I shouldn’t have to have debt to get credit, it seems stupid and backwards!

I appreciate your frustration when it comes to credit ratings/scores. They are maddening if you expect them to function like common sense suggests. This isn’t going to change your mind but credit scores are completely driven based on what’s predictive of your risk as a borrower. Some things matter and some things don’t.

Now, having said that, your comment about having debt being necessary to get credit is absolutely incorrect. In fact, not having debt is much better because of the infamous “DTI” ratio. DTI, or debt-to-income, is the amount you pay each month to satisfy debts, relative to your income. The fewer debts you have, the better your debt-to-income percentage and the more likely you are to be approved for large loans, like mortgages.

Additionally, I can assure you as someone who spent seven years with his hands deep inside the FICO scoring system, that paying your bills is handsomely rewarded by FICO. The most important factor in your FICO score is your payment history. The absence of negative information, which means you always pay your bills on time, is worth 35% of the points in your scores.

The issue of having debt in order to have a good credit score or get more credit is widely misreported, mostly by people who simply don’t understand credit scoring. You don’t have to have one penny of debt (or ever had one penny of debt) to have FICO scores well into the 800s. FICO scoring has no memory, so they don’t know what your debt was yesterday, the day before, or 5 years before.

Now, I know what you’re thinking: When you apply for credit you’re getting into debt. That’s incorrect. Every single credit card you have ever opened starts off with a $0 balance. And, if you pay your bill in full each month, then you never have credit card debt.

Taking out loans, such as mortgages, auto loans, student loans or personal loans, certainly does mean you’re getting into debt. However, this is certainly considered a very different type of debt than that vile credit card debt, which, incidentally, is much less as a country than our student loan debt. And, FICO weighs that installment form of debt very differently than it weighs credit card debt. It’s quite easy to have great FICO scores even with large amounts of installment debt.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. Follow John on Twitter.