by David Lucht
A lasting effect of the Great Recession has been the growing number of professionals caught in the real estate devaluation of residential properties. In the past, steady property appreciation seemed to make any home mortgage safe for the bank and owner. But the last several years have led to many borrowers finding they owe more than their homes are worth.
Some borrowers have decided the best option is to sell the home, with the bank's permission, for less than what is owed. The amount of loan still unpaid after the sale is called a "deficiency balance” or "short sale,” which may or may not be forgiven by the bank.
The impact on credit scores
Not surprisingly, a short sale has a huge negative impact on the borrower's credit score, regardless of whether the loan was current before the sale. According to an April 2011 CNNMoney article, a 780 credit (FICO) score will see a 160-point drop following a short sale, while a 680 score will see an 85-point drop. This is the same magnitude drop as from a foreclosure.
Like all negative credit listings, this will remain on the credit record for a number of years. The question we hear repeatedly from potential practice owners is, "How will this affect my ability to arrange practice financing?” or "How is this black mark on my credit score perceived by decision makers at a bank?”
How to find financing
The effect on practice financing depends on the flexibility of your lender's credit standards, the circumstances surrounding the short sale, and other credit factors involved with the practice acquisition.
The first area to investigate is the flexibility of credit standards. Some banks require a minimum FICO score for their borrowers with no exceptions. Typically, this score is around 650. If you have a short sale on your record, especially a recent one, your score will probably be below this minimum.
Likewise, a bank may have a policy to never finance anyone with a short sale or bankruptcy on his or her credit report. If the bank is unwilling to bend, do not get discouraged. Keep searching for a bank that will listen to your situation.
Working with the bank
The second factor a bank will consider is the circumstances surrounding the short sale. If you had the income to support the mortgage payment but chose to walk away because there was no equity in the property (strategic default), that will likely be perceived negatively by the banker. Was the loan kept current until the short sale? If so, this can mitigate the negative perception.
If, however, you needed to leave the area for a job, or experienced an interruption of income that led to the inability to pay, the resulting short sale might be viewed more neutrally.
It will be extremely helpful to your case if all other debts have been paid in a timely manner. If the short sale is the only blemish on your credit report, it will be easier to explain. If several other accounts were delinquent or charged off, you will probably find fewer banks willing to listen to the circumstances of the short sale.
Bottom line: Be prepared to honestly describe what happened, and show how you were trying to work with your bank to resolve a difficult situation.
Finally, the bank will likely ask the following questions to gauge the overall strength of the loan request:
- Is the cash flow of the practice growing and healthy?
- Have you demonstrated skills to succeed not only as a great dentist but also as a great business owner?
- Is the purchase price of the practice reasonable?
- Are you purchasing the practice with a partner who has no personal credit blemishes?
- Do you have a terrific transition plan that shows you understand the practice's competitive position in the market, and can successfully accomplish the ownership change without losing clients?
If too many of these questions are answered negatively, the short sale can probably not be overcome by the lender. But if answers are positive, the short sale may not prevent you from obtaining the loan.
A bank's credit decision is always a judgment call. A weakness in one area can be offset by strengths in other aspects of the loan request. Be sure to highlight why the loan is a safe risk for the bank. Do not avoid talking about the short sale, but show why you are confident that the loan you're requesting will succeed.
David Lucht is the chief risk officer for Live Oak Bank. Before joining Live Oak Bank in May of 2007 as a founding member, Lucht held high-ranking positions in many different successful banking institutions. He was the chief credit officer, executive vice president, and director for First Merit Bank out of Akron, Ohio, where he was responsible for leading the turnaround in credit culture and performance of the $10.5 billion bank.
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