Bankruptcy? Foreclosure? Short Sale? Loan Modification? When you’re struggling to pay debts, these credit events can make you worry about your FICO score. The truth is, any of these may reduce your creditworthiness. Simply put, your credit score can affect whether you qualify for another mortgage, a car loan, a credit card, or other financing. A lower score can also mean that the credit you do qualify for costs more.
Credit Event Effect On FICO Score
In Arizona, just like in other states, your FICO score is calculated using information in your credit reports. The effect of any negative event depends on:
- what your credit looked like before the event
- how many accounts are affected
- whether you were already behind on payments
- how the creditor reports what happened
FICO itself warns against assuming that the same credit event will cause the same point drop for everyone. In FICO’s own examples, a person starting with very strong credit can lose far more points after a serious delinquency than a person whose credit report already contains several negative items.
So, if you are asking which one is generally worse, here is an overview of the different credit events and how each may affect your FICO score:
Bankruptcy May Have The Broadest Effect On Your FICO Score
In general, bankruptcy causes the greatest credit damage. Because it often involves more than one account, it creates a very negative effect on your FICO score. Bankruptcy exposes almost your entire credit profile – which may involve credit cards, personal loans, medical debts, mortgages, auto loans, and other accounts simultaneously.
Someone who had excellent credit before filing may experience a much larger decline than someone whose report already contains late payments, collections, charge-offs, and other serious problems. FICO also notes that the number of accounts included in the bankruptcy can affect the impact on your score.
Bankruptcy can also stay on your credit report longer than most other negative events. According to the Consumer Financial Protection Bureau:
- A Chapter 7 bankruptcy can generally remain on a credit report for 10 years.
- A Chapter 13 bankruptcy generally remains for 7 years.
That does not mean your credit score remains frozen at its lowest point for seven or ten years. FICO explains that the negative effect of bankruptcy decreases as time passes. If you begin establishing a positive credit history after bankruptcy and consistently pay new obligations on time, your score can begin recovering while the bankruptcy is still visible on your report.
Bankruptcy Can Still Make Financial Sense Even If It Hurts Your Credit More
Do not assume the option with the worst credit impact is automatically the worst financial choice.
For instance, imagine you have a 700 FICO score but can no longer pay your mortgage, credit cards, medical debt, and personal loans. You might be tempted to avoid bankruptcy because you want to protect your score. But if you continue missing payments on five or six different accounts for another year, your credit may deteriorate anyway while interest, late fees, lawsuits, and collection activity continue.
Bankruptcy may sometimes give you a way to deal with several debts at once. Whether that benefit outweighs the credit consequences depends on your circumstances.
Bankruptcy law is primarily federal, but Arizona law can still matter because it provides exemptions that may determine whether certain property is protected. For example, A.R.S. § 33-1101 provides Arizona’s homestead exemption and expressly addresses how the homestead exemption operates in cases filed under Title 11 of the United States Code. The statute currently provides a $400,000 statutory amount and requires annual cost-of-living adjustments beginning in 2024.
That exemption issue is separate from your FICO score. An Arizona exemption may help you protect property in a bankruptcy case, but it does not erase the bankruptcy from your credit report.
Foreclosure Is Extremely Damaging, But May Be Less Severe than Bankruptcy
A foreclosure occurs when the mortgage lender ultimately takes or sells the property after the homeowner defaults on the mortgage.
Yes, it is damaging, but another major source of credit damage usually occurs before the foreclosure is completed: missed mortgage payments.
Payment history is one of the major factors used in credit scoring. A homeowner might become 30, 60, 90, or more days delinquent before the foreclosure occurs. Thus, by the time the foreclosure appears on the credit report, substantial damage may already have occurred.
The CFPB confirms that foreclosure negatively affects credit and generally remains on a credit report for approximately seven years.
Experian likewise explains that bankruptcy generally has more severe credit repercussions than foreclosure. Chapter 7 bankruptcy can remain on credit reports for ten years, while foreclosure generally remains for up to seven years.
For example, David has a strong credit history but stops paying his mortgage after his income drops.
His mortgage becomes:
30 days late → 60 days late → 90 days late → 120 days late → foreclosure.
His FICO score may decline substantially during the delinquency period even before the foreclosure is completed.
This is important when comparing foreclosure with other alternatives. A homeowner should not assume that the foreclosure event alone creates all of the credit damage.
How Foreclosure Works Under Arizona Law
Under A.R.S. § 33-807, a trustee has the power to sell trust property after a breach or default. The statute also allows a beneficiary to pursue judicial foreclosure instead. For a trustee’s sale, Arizona law provides that the trustee’s power of sale cannot be exercised before the ninety-first day after the notice of sale is recorded.
That state-law timetable does not give you a 91-day grace period for your credit score. Your mortgage may already be reported delinquent while the foreclosure process is moving forward.
For example, suppose you own a home in Phoenix and stop making your mortgage payments in January. Your lender eventually begins the trustee’s sale process. Even if the trustee’s sale does not occur until months later, your credit report may already show serious mortgage delinquencies. By the time the foreclosure itself appears, much of the damage may already have happened.
Arizona’s Anti-Deficiency Law Can Protect Your Money, But It Does Not Protect Your FICO Score
Under A.R.S. § 33-814(G), if qualifying trust property is two and one-half acres or less, is limited to and used for a single one-family or single two-family dwelling, and is sold through the trustee’s power of sale, the lender generally cannot bring an action to recover the difference between the sale amount and the outstanding debt. The statute contains exceptions, including certain properties involving builders and certain dwellings that were never substantially completed or never actually used as dwellings.
Here is a simple example.
Suppose you owe $420,000 on your Arizona home when the trustee’s sale occurs. The property brings only $350,000 at the sale. That leaves a $70,000 difference.
If your property and loan situation fall within A.R.S. § 33-814(G), the lender generally cannot sue you for that $70,000 deficiency after the trustee’s sale. It does not, however, mean the foreclosure disappears from your credit report.
Arizona’s anti-deficiency law answers a different question: Can the lender pursue you personally for the unpaid difference? It does not tell FICO to ignore the missed mortgage payments or the foreclosure.
When the anti-deficiency protection does not apply, Subsection A allows a deficiency action within 90 days after a trustee’s sale. It uses a fair-market-value calculation when determining the amount of the deficiency. If no qualifying deficiency action is brought within the statutory period, subsection D provides that the sale proceeds are treated as satisfaction of the obligation.
Arizona also has a separate anti-deficiency rule for certain purchase-money mortgages that are judicially foreclosed. A.R.S. § 33-729 protects qualifying residential property of two and one-half acres or less when the mortgage was used to secure the purchase price or a loan used to pay the purchase price. The statute contains exceptions, including some construction-related property and certain incomplete or unused dwellings.
Again, these protections may make a huge difference to your finances. They do not prevent accurate foreclosure information from affecting your credit.
Short Sale May Be Better than Foreclosure But It Still Hurts Credit
A short sale occurs when the mortgage lender allows the homeowner to sell the property for less than the amount owed on the mortgage.
Homeowners sometimes assume that a short sale will barely affect their credit because they voluntarily sold the property instead of allowing the lender to foreclose. However, it just means the mortgage debt was settled for less than the full amount owed.
Experian explains that the words “short sale” may not necessarily appear on the credit report. Instead, the mortgage may be reported using language indicating that the account was settled or legally paid for less than the full balance. That is still negative credit information.
Nevertheless, a short sale can be less damaging than foreclosure, particularly when the homeowner continues making mortgage payments until the sale closes.
Experian notes that a short sale conducted without missed mortgage payments can result in less credit damage than foreclosure. This is because foreclosure normally involves significant delinquency before completion.
Example 1: Short Sale Without Missed Payments
Suppose John owes $350,000 on his mortgage, but the lender approves a $300,000 short sale.
John continues making his mortgage payments until the sale closes.
His credit report may still show that the mortgage was settled for less than the full balance. His FICO score may therefore decline.
However, he avoids adding months of 30-, 60-, 90-, and 120-day late payments to his credit history.
That can make the credit consequences considerably different from those of a completed foreclosure.
Example 2: Short Sale After Months of Delinquency
Now suppose John stops making payments six months before completing the short sale.
His report contains several serious mortgage delinquencies plus the settlement for less than the amount owed.
In that situation, the credit advantage of the short sale over foreclosure may become much smaller because much of the damage has already occurred through the missed payments.
Experian specifically notes that the precise effect of a short sale depends on such factors as:
- existing delinquencies
- overall credit file
- scoring model
- deficiency balance report
Therefore, it is inaccurate to say that a short sale always causes a particular number of points of damage or is always dramatically better than foreclosure.
Be Careful About The Remaining Debt After An Arizona Short Sale
There is another Arizona issue that is just as important as your credit score.
If you sell your property through a short sale, you should determine exactly what happens to the unpaid part of the mortgage.
For example, suppose you owe $400,000, and the lender approves a short sale for $350,000. You have a $50,000 shortage.
Do not assume that because the lender approved the sale, the lender necessarily agreed to forgive every dollar of that shortage.
Arizona’s trustee-sale anti-deficiency protection in A.R.S. § 33-814(G) specifically addresses property sold pursuant to the trustee’s power of sale. A voluntary short sale is a different transaction.
Arizona real estate materials have long advised sellers to obtain legal advice about the terms of a short-sale agreement. In addition, the Arizona Department of Real Estate’s current educational curriculum specifically treats foreclosure, short sales, deeds in lieu, and Arizona anti-deficiency law as distinct issues that require an understanding of the applicable deficiency rules.
If you are considering a short sale, read the approval letter closely. You want to know whether the lender is merely releasing its lien so the property can be sold or is also releasing you from personal responsibility for the remaining debt.
Loan Modification Usually Has The Least Impact On FICO Score
Of these four alternatives, a loan modification is generally the most credit-friendly option. It allows the homeowner to remain current and avoid foreclosure.
A mortgage modification changes one or more terms of the existing mortgage. Depending on the program, the lender might change the interest rate, repayment period, payment structure, or other terms to make the loan more manageable.
FICO explains that when a loan modification is reported as the same loan with changed terms, the effect associated with those changes should be minimal. Factors such as a credit inquiry, the balance, and the loan’s changed terms may affect the score somewhat.
The situation becomes more complicated when the borrower was already delinquent before receiving the modification.
Example
Suppose Angela realizes that she will soon be unable to afford her mortgage payment.
Instead of simply stopping payments, she contacts the servicer and qualifies for a modification that reduces her monthly payment.
If she remains current and the modification is reported as a change to the existing mortgage, the credit impact from the modification itself may be relatively small.
Now assume Angela waits until she has missed four mortgage payments before obtaining the same modification.
The modification may ultimately help her, but her credit report may already contain substantial delinquencies. The modification does not ordinarily erase accurate previous late payments.
Experian therefore cautions that much of the credit damage associated with a modification situation may already have occurred before the modification if the homeowner missed payments.
Moreover, the CFPB notes that accurate negative information cannot simply be removed from your credit report because you later resolved the underlying problem. Most negative account information can generally be reported for seven years, although its effect on your score usually becomes less important as it gets older.
That is why contacting your mortgage servicer early can matter. Simply contacting the servicer and asking questions does not itself affect your FICO score. FICO says that if the servicer needs to pull your credit, it must obtain permission, and an inquiry may have only a small effect.
Your Starting Credit Score Makes A Big Difference
You may assume that if an event is serious, everyone loses roughly the same number of points. That is not true.
Suppose you have never missed a payment, use little of your available credit, have a long credit history, and have a FICO score close to 800. A new 90-day mortgage delinquency represents a dramatic change in your credit profile.
Now suppose another borrower already has a score around 600, several credit-card delinquencies, a collection account, and high revolving balances. Another negative event can still hurt, but the additional score decline may be smaller because much of that borrower’s existing credit risk is already reflected in the score.
FICO demonstrates this point in its own scoring simulations. Its examples show that people starting with stronger credit can experience significantly larger point declines from the same delinquency than people whose reports already contain negative information.
Do Not Ruin Your Finances Just To Protect A Credit Score
Your credit score is important, but it is designed to measure credit risk. It is not a measure of whether a particular legal decision is good for you.
Thus, be cautious about draining retirement savings, borrowing from family, taking expensive new loans, or using every dollar of emergency savings simply because you are trying to keep a particular FICO number.
If the underlying debt is no longer manageable, preserving a score for another few months may only delay the problem. At the same time, you should not file bankruptcy or allow a foreclosure to happen merely because you assume your credit is already ruined. The details of your mortgage, your other debts, your income, your home equity, and Arizona’s deficiency protections can change the analysis substantially.
That is why you should look at the entire financial picture rather than one number on a credit-monitoring app.
Can You Rebuild Your Credit After Bankruptcy or Foreclosure?
Yes. A serious negative event does not mean you will have bad credit forever.
Credit consequences should not be the only consideration when deciding how to deal with an unaffordable mortgage or overwhelming debt.
A homeowner may also need to evaluate:
- whether keeping the home is financially realistic;
- the amount of mortgage arrears;
- other unsecured debts;
- potential mortgage deficiency liability;
- available income;
- bankruptcy eligibility;
- tax consequences of forgiven debt;
- eligibility for mortgage-loss-mitigation programs; and
- how quickly the household can return to a sustainable financial position.
Sometimes accepting short-term damage to a FICO score can be preferable to continuing an unsustainable financial situation.
Considering all the credit events mentioned above, bankruptcy creates the broadest adverse credit consequences of these alternatives. Nevertheless, it can also provide remedies unavailable through foreclosure or a short sale, including the federal automatic stay and, in an appropriate Chapter 13 case, an opportunity to cure mortgage arrears and prevent foreclosure.
In addition, an Arizona issue worth emphasizing is second mortgages and HELOCs. Their treatment can be substantially different from the first mortgage after a trustee’s sale, particularly when the junior loan is non-purchase-money debt.
Credit Score Improvement
Credit scores can also improve over time. The CFPB notes that newer negative information generally has a greater effect than older negative information. Consistently paying new and remaining obligations on time can therefore become increasingly important during the rebuilding process.
If you continue missing payments, maxing out credit cards, and sending accounts to collections, recovery will be difficult. But if you pay new obligations on time, keep balances manageable, avoid unnecessary new debt, and regularly review your credit reports for errors, your credit history can gradually improve.
You should also check your credit reports after a bankruptcy, foreclosure, short sale, or modification. Accurate negative information generally cannot be removed simply because you dislike it, but inaccurate information can be disputed. The CFPB states that you have the right to dispute errors with both the credit reporting company and the company that supplied the information.
If you live in Arizona, you also have to look beyond your credit score. Arizona’s deed-of-trust and anti-deficiency laws can make a major difference in how much money you may still owe after losing a property. A.R.S. § 33-807 governs trustee’s sales; A.R.S. § 33-814 contains important deficiency and anti-deficiency rules following trustee’s sales; and A.R.S. § 33-729 provides separate protection for certain purchase-money mortgages.
The option that causes the smallest drop in your FICO score is not always the option that saves you the most money, protects you from the most debt, or gives you the best chance to recover financially. So, before you decide between a loan modification, short sale, foreclosure, or bankruptcy, understand what happens to your credit and what happens to the debt after the property is gone.