Rebuilding credit following a foreclosure

There's good news and bad credit news for those enduring a foreclosure.

First, the bad news: Foreclosures have a devastating impact on your credit score.

The offsetting good news is that the impact will not last forever, and there are steps you can take almost instantly to begin rebuilding your credit score.

Foreclosures kill your credit

"It's a pretty serious hit," says Rebel A. Cole, professor of finance at DePaul University's College of Commerce, noting it's not unusual for a foreclosure victim to watch helplessly as 100 to 200 points are slashed from their credit score.

If, for instance, your credit score went from the low 700s to the high 500s, "that's sub-prime," says Cole. "You're not going to be able to get credit very easily. It will be very difficult [at that level] to get anything other than secured credit."

Foreclosures credit damage sticks for a long time

A foreclosure can stay on your credit report for up to seven years, says Maxine Sweet, vice-president of public education at the Costa Mesa, Calif.-based credit bureau Experian. "At that time, it will be automatically erased," she adds. Distressed homeowners can also get out from under their homes by a deed in lieu of a foreclosure and by pursuing a short sale.

"When you do a short sale, you close out the loan for less than you agreed to pay originally, and so that's a settled account," Sweet says. "That account is reported as being settled rather than being reported as foreclosure."

Different time lines for getting a new mortgage

If a bit of time has passed between your foreclosure and your next home application, you may qualify for prime mortgage rates. Here are the standard waiting periods for most mortgage programs:

Fannie Mae and Freddie Mac: 7 years
FHA loans: 3 years
VA (veterans and military): 2 years
USDA (rural and some suburban housing): 3 years

If the foreclosure was due to circumstances outside of your control that can be documented, these "extenuating circumstances" can shorten the above time periods by as much as half. You'll need to talk to a mortgage lender for more details and qualifications.

How to rebuild your credit after foreclosure

Many like to talk about the idea of "repairing" a credit score after a foreclosure. But the words "repair" or "repairing" are misnomers in this context, Sweet says.

"That implies you will undo what you've done," she explains. "You have to start from this point forward rebuilding your credit."

The most important thing you can do to rebuild your credit score is to manage credit without spending more than what you can pay each month, Sweet says.

"More important than improving your score is getting your spending under control. The best way to rebuild your credit score is to use your credit card regularly, and pay in full each month, so you're demonstrating you are in control, you can manage risk, and you're not a risk to the card companies. That will start adding positive points to your credit history each month."

As an example, she cites folks who started with a mid-range credit score of 650 to 700, then went into foreclosure. If they actively used credit and paid it off each month, they were able to return their credit score to earlier levels in nine months.

"If you aren't doing that, and you stop using credit, you've frozen your credit history in a negative state," Sweet says. "There's nothing to offset this negative history. You overcome that by using credit in a 'credit smart' way."

Credit utilization impact

The second most important factor in determining a credit score is how much is owed on credit cards compared with on the amount of one's credit limit, a ratio known as credit utilization.

If cardholders have unpaid balances on their credit cards, they can start paying down the balances and increasing the amount of unused credit they have.

"It's a sign of high risk when someone is charged to the max on their credit cards," Sweet says, noting that reducing the amount owed on cards is "one of the very, very specific things they can to do rebuild their credit scores."

One final word of wisdom to those facing foreclosure: If you can get into a loan modification without missing a mortgage payment, you will avoid a black mark against your credit score.

Unfortunately, though, before most people can get into a loan modification, they have either missed payments or have found the modification program forces them to miss payments, Sweet says.

"But still, a missed payment does not have as serious an impact on your credit score as a foreclosure," she adds.

This article was revised by Keith Gumbinger.

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