If you can't refinance to today's lower mortgage rates, and you're having money problems, you may be able to modify your home loan. By doing it the right way, you can minimize the damage to your credit score.

Modify Your Mortgage Without Wrecking Your Credit

If you are suffering from financial hardship (officially defined as a 25% decrease in income, a 25% increase in expenses, or some combination of the two), it may be impossible to refinance your mortgage. This goes double if your property has lost equity.

For those who can't refinance their mortgage, lenders may be willing to modify home loans under the Home Affordable Modification Program (HAMP) or even outside of any government-sponsored option. And you don't have to ruin your credit in the process. A study by Vantage Score Solutions--a joint venture created by the three national credit bureaus--found that many commonly used mortgage modification strategies can be pursued without inflicting serious damage to your credit score.

Loan Modification Strategies

• Reduced/deferred payments. According to the study, borrowers who were granted a payment modification suffered only a 30- to 40-point hit to their credit scores. Keep in mind that these were borrowers who had good credit to begin with and who did not miss mortgage payments. Those who were allowed to defer (skip) payments saw their credit scores affected much more.
• Principal reduction. This is recorded as a partial charge-off and carries a significant credit score bomb, similar to a foreclosure or short sale.
• Trial modification. According to HAMP guidelines, borrowers who make their modified mortgage payments on time throughout a trial period may not be reported as late by their mortgage servicer--as long as the borrower is current on the mortgage when he or she enters the trial period. If you are delinquent on your home loan payment when your start a trial period, you are reported late the entire three months or so that you're in the trial. So bring your mortgage current before you begin a trial modification to avoid credit damage.
• Short sale. According to the study, a short sale can knock 130 points off your credit score. But the way a non-government short sale (or a deed in lieu of foreclosure, for that matter) is reported to credit bureaus is entirely up to the mortgage lender: it's negotiable. Some borrowers manage a complete walk-away with a "paid-satisfied" notation. Others get "charge off" for exactly the same property disposition. If your credit rating is very important to you--for example, if you work in the finance or insurance industries--you may want an attorney to help you negotiate with your lender. If you sell your home through the Home Affordable Foreclosure Alternative (HAFA) program, the lender gets very specific direction from the HAMP administration about credit reporting. In this case, you're better off being current on your mortgage when the sale goes through, but you will take a significant hit to your credit rating.

Protecting Your Score

In some cases, borrowers who were already behind on their mortgages improved their scores after modification. For example, those who had several months of missed payments, late charges, and collection fees could get the arrearages capitalized--added to the loan's balance--and their loan reported as current once again. Scores went up in such instances.

Rebuilding Your Score

Don't think that all is lost with your credit score after loan modification. Amazingly, homeowners whose credit scores were near 600 (not exactly a stellar rating) in the wake of a mortgage modification saw them rebound to 700 in nine short months of perfect payment history.

Mortgage Is King

Many homeowners don't realize that credit bureaus rate mortgage payment histories a lot more heavily than payments to revolving accounts. In order of importance, it's mortgage, then secured loans like auto loans, then unsecured debt like credit cards. So people who skip mortgage payments to keep American Express happy are doing their credit scores a serious disservice.