Short Sale vs Foreclosure: What Is It, and How Does It Affect Your Credit?

What does “short sale” mean? “A short sale in real estate occurs when the outstanding obligations (loans) against a property are greater than what the property can be sold for.”

In this time of option-arms coming due we will see more and more borrowers trying to negotiate short sales as opposed to going into foreclosure. In most cases the borrower will be behind on payments and about to go into foreclosure, however this will not always be the case. Some short sales are negotiated simply because a borrower knows they are upside down on their mortgage but has not reached the point where they have late payments. For example, the borrower’s loan is interest only and they have been unable to make principal payments. The original loan amount was $250,000 and they have been making the minimum payment and the loan balance has increased to $263,000.At the same time, the home only appraises for the $250,000 or possibly even less.Because the option-arm period is up, the borrower’s mortgage payments will increase and they are unable to make the higher payment. There is no equity in the property and they cannot sell the home to cover the balance of the loan. At this point they can either try to negotiate a short sale with the lender or go into foreclosure.

If the lender agrees to a short sale, they are buying back the loan for less then what they are owed. This is not something a lender has to do, but it is an option for them. Why would they consider this? The real cost for the lender in a foreclosure action is that they have to carry the loan until they can resell the house. They have to pay the taxes and insurance and this can take time and the cost of carrying the loan can become quite substantial. In some cases it will be more beneficial for them financially to take the short sale.

How does it affect credit? Typically the loan will show up on a credit report as “settled for less then the full balance”. This will have a negative impact on the borrowers score,however it will be less then if it shows as “foreclosure”. How much it will actually affect the score will depend on the rest of the borrowers credit history. It is always best to have an attorney negotiate a short sale with a lender and at the same time have them negotiate how it will appear on the credit report. Some lenders will agree to show the loan as “paid with no late payments” (providing the borrower hasn’t made any) or they may show it as “paid was 30” if there have been some late payments. This would be optimal.

A short sale can also have a negative affect on a borrowers credit if the lender issues a deficiency judgment. A lender may take this route even if they show the actual mortgage on the credit report as paid as agreed. When they take the short sale there is still a difference between the actual mortgage balance and the amount of the short sale. The lender can then issue what is called a deficiency judgment against the borrower and this will show on a credit report just as any other judgment would. The attorney should attempt to get the lender to accept “payment in full without pursuit of any deficiency judgment.” Sometimes the lender will put the borrower on a payment plan for the deficiency without issuing a judgment. Again, this would be optimal.

The one instance where a lender will not consider a short sale is if the borrower is in bankruptcy. Lenders consider a short sale payoff as a collection activity and collection activities are prohibited once a person has filed bankruptcy.