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A reader sent in a question recently about an important topic — short sale vs. foreclosure. This was a big issue a decade ago during the financial meltdown when millions of people were losing their homes. It’s not as common today, but if you’re under extreme financial stress and struggling with your mortgage, for example, your mortgage balance is greater than the value of your home, this is a very relevant question.

If you sell using a short sale, how does this affect your credit score? How many points will it reduce your score by? Would you be better off credit-wise by just letting the house go into foreclosure?

There’s a lot more to the short sale vs. foreclosure question than just the impact on your credit score. We will discuss this point along with other important issues associated with either a short sale or a foreclosure.

Table of Contents:

  • What is a short sale?
  • What is a foreclosure?
  • Short sale vs. foreclosure: how they affect your credit
  • Short sale vs. foreclosure: the deficiency balance factor
  • Which is better: a short sale or a foreclosure?

What is a short sale?

A simple explanation is that a short sale takes place when a person sells a house for less than the amount of debt they owe on it. However, there’s a lot more to it.

It’s generally assumed that someone will sell their home for more than the amount they owe on it, but that’s not always the case. When you sign the mortgage papers for your new home, you’re not just pledging the property as collateral for the loan, you’re also pledging your personal financial resources. That is, if the proceeds from the sale of the property are insufficient to pay off the mortgage, you’ll need to pay the deficiency out of your personal assets.

However, in the case of a short sale, the property seller is distressed, as they can no longer afford to make the monthly payments. Not only is the property value less than the amount of the loan owed on it, but the seller has no available personal assets to make up for the deficiency. Therefore, the distressed homeowner needs to sell the property to avoid foreclosure.

A short sale, if it’s possible, is generally better than a foreclosure. With a short sale, the property seller can arrange a more graceful exit. That is, they can stay in the property until it’s sold. Furthermore, there are fewer add-on fees that typically come with a foreclosure, particularly legal fees.

The mechanics of a short sale

As desirable as a short sale may be, they’re not easy to arrange. First, your lender has to agree in principle to the short sale. Second, the lender must approve any contract offer on your home.

Naturally, the lender will be more likely to accept a contract that is closer to paying off the entire mortgage balance. If the lender is going to take too big a loss, they may decline the contract offer and the short sale.

The back-and-forth negotiations with the lender can take many months — and several failed attempts — before completing a short sale. The lender may also opt for foreclosure if it’s believed it will result in a smaller loss.

What is a foreclosure?

A foreclosure is a legal process implemented by the lender when the borrower defaults on a mortgage. It typically occurs after the borrower misses a certain number of monthly payments. Exactly how many payments will depend on the laws in your state of residence.

As your home serves as collateral for the mortgage, the lender has a legal right to seize the property in satisfaction of the loan once you are in default.

The mechanics of a foreclosure

The lender must first serve you with a notice of default. You’ll generally have a certain amount of time to correct the default, or the lender will implement foreclosure proceedings.

If the lender is in control of a short sale, the situation is even more pronounced with a foreclosure. Many states have a process known as judicial foreclosure, in which the lender must go through the courts to legally foreclose. Other states have nonjudicial foreclosure (which is a quicker process), in which the lender does not need to go through the courts and can foreclose after a series of notifications.

Once foreclosure takes place, the sheriff seizes the property, forcing the occupants to evacuate. As the new owner of the property, the lender will either auction the property on the courthouse steps or put it on the market to satisfy the outstanding mortgage balance.

There are consequences regardless of whether a home sells through a short sale or seized in foreclosure.

Short sale vs. foreclosure: how they affect your credit

As you might expect, either a short sale or foreclosure will have a negative, or even devastating, effect on your credit score. Even several late mortgage payments can have a catastrophic effect on your credit score. A short sale or foreclosure will lower your score even more and have a longer-lasting effect.

According to Fico.com, a consumer with a pre-crisis credit score of 720 can expect the following results from either outcome:

  • Short sale with no deficiency balance, credit score falls to 605 to 625
  • Short sale with a deficiency balance, credit score falls to 570 to 590
  • Foreclosure, credit score falls to 570 to 590

As you can see, the best outcome is from a short sale with no deficiency balance, but even then the credit score falls by at least 100 points. For a short sale with a deficiency balance or a foreclosure, it can fall as much as 150 points.

Credit recovery from a short sale or foreclosure

From a timing standpoint, the derogatory fallout from each of the three outcomes will remain on your credit report for at least seven years. Fortunately, it will have a less negative impact on your credit score with each year that passes.

However, even as your credit score increases, either a short sale or foreclosure can still have a negative impact. For example, you have to wait a minimum of two years after a foreclosure or short sale before applying for a new mortgage. This guideline applies to both conventional and Federal Housing Administration (FHA) mortgages.

Furthermore, you need to be aware that even though you may be eligible to reapply in as little as two years, your credit score may not be high enough to qualify, particularly on a conventional mortgage. You may not be able to get other types of loans, particularly credit cards, if you’ve had a foreclosure or a short sale within the past seven years.

Short sale vs. foreclosure: the deficiency balance factor

This is probably a bigger dilemma for most people than the credit score hit. When your house sells for less than the amount you owe on it, there’ll be a deficiency balance. This will create one of two problems:

The lender will continue to pursue you for payment of the outstanding loan balance. This can include getting a court judgment against you, with the potential to garnish your wages and bank accounts.

The lender will issue IRS Form 1099-C Cancellation of Debt. Under IRS regulations, if the lender cancels your debt as uncollectible, it’s considered income to you. It’s then taxable and will need to be reported when you file your tax return.

In the second case, the tax liability may be considerable if the amount of written-off debt is particularly large. For example, a $100,000 cancellation could result in a tax liability of $30,000 if you have a combined federal and state marginal income tax rate of 30%.

Dealing with the deficiency balance factor

If you’re facing a large deficiency balance, bankruptcy might be your best option. A deficiency balance can be discharged through either Chapter 13 or Chapter 7 bankruptcy.

The major downside of the bankruptcy route is that you will have a foreclosure and a bankruptcy on your credit report, and your credit score will take many years to recover from this combination. Therefore, it might be best to file for bankruptcy and include your house in the proceedings rather than face foreclosure.

A second option, as far as avoiding the tax liability of a mortgage deficiency, is an exemption under the Mortgage Forgiveness Debt Relief Act of 2007. This currently applies to mortgage deficiencies incurred through 2017, but Congress has renewed this annually.

If you do receive a 1099-C for cancellation of debt, you’ll need to discuss your possible exemption status under the Act with a certified public accountant (CPA), particularly if it is a large amount.

Which is better: a short sale or a foreclosure?

As you can tell from this discussion, the difference between a short sale and a foreclosure is mostly cosmetic. Either can destroy your credit score and leave you with a deficiency balance that you’ll either need to pay to the lender or declare taxable income on your tax return.

A short sale may have a slight advantage in that you’ll avoid the embarrassment of having a foreclosure. Unfortunately, foreclosure comes with certain social ramifications that most people hope to avoid. On a more substantial note, a short sale will give you a better chance of vacating your home on your terms, rather than through a sheriff’s sale.

If you’re facing the possibility of a short sale vs. foreclosure, discuss the implications of both with a real estate attorney and/or a CPA. Either route is a complicated process.

Disclaimer: This story was originally published on May 30, 2009, on BetterCreditBlog.org. For more information on Short Sales or Foreclosures, please visit: https://www.rocketmortgage.com/learn/short-sale-vs-foreclosure