How a Short Sale Charge Off Effects Your Credit

Will a charge-off hurt my chances of buying a home?

I had one of my clients talk to me this week about their credit report. They are in the market to buy a home, and they did the right thing by going to the bank first to see how much house they could afford to buy with a loan. The loan officer did a quick look at their credit and found a charge-off on a past mortgage.

 

My clients had relocated and purchased a second home years ago outside California, in the 2005 real estate boom. As their work circumstances changed and the second home mortgage costs began to escalate, they were forced to do a short sale on the property. As part of the process, the lender who had the 2nd mortgage on the property (Jr. lien holder) reported the debt as a charge-off, meaning they were paid less than was owed to them at the time.

 

Unfortunately for my clients, they were told that the primary lender had paid off the secondary lender (which was true), but the secondary lender reported the amount owed as a charge-off, which is damaging to your credit.

 

Let’s first look at what a charge-off is and is not. A charge-off is simply an accounting entry. A bank or other lender considers your debt to be an asset. It’s an asset because it has value. But if you get behind in your payments, then obviously the value of that asset falls into question. And, after a while, the IRS requires the bank to remove your loan from its assets. The bank then “charges off” part or all of your loan from its books.

 

So a charge-off for the bank/lender is an accounting activity. But for you it is a report that goes to the three credit reporting agencies and gets incorporated into your credit score. If you have a loan marked as charged off, no doubt about it, it will hurt your credit score. A charge-off will remain on your credit report for seven and a half years from the time it occurred.

 

Here’s the bad part for my clients, and others in short sale situations. What a charge off will not do is release a person from his or her debt. Even if an account is charged off, you still owe the money. And, as it turns out, it may even make it more difficult to repay the debt afterward. How a Short Sale Charge Off Effects Your Credit:

 

Here’s why. When a bank charges off a debt, it will typically do one of three things:

 

You have no control over when a debt is charged off. That’s determined by the law and the lender. Even if you have every intention of repaying the loan, it may still be charged off. A credit card account is usually charged off when the customer fails to make minimum payments for 6 months, but loans can take much longer before it is reported as a charge-off.

 

As we mentioned, this action will hurt your credit score. Thirty-five percent of your score is based on your payment history. Any late payments will lower your score. So the charge-off hurts, but most of the damage has already been done by the late payments. The higher your score was to start with, the greater the damage will be.

 

Once a debt is charged off, it will be tempting to not to pay it even if you have the money to do so. You may want to reconsider, especially if you are considering buying a home. Often the collections agency or department that holds the debt will settle for less, usually about 10% of what is owed. Obviously if you had a $300,000 loan, setlling for $30,000 might not make sense because it will lower your cash reserves to buy the next house. If the settlement amount is under $10,000 with the collections department, it probably makes a lot of sense.

 

It’s complicated – if I can help or answer questions, please feel free to Call Colin at (714) 743-9882 or E-mail me.

 

If I don’t know the answer, I know other people who do and can help you, especially an accountant.