I received a reader question that opens 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 underwater on your mortgage – meaning 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? Would I be better off credit-wise by just letting the house go into foreclosure?
There’s a lot more in the short sale vs. foreclosure question than just the impact on your credit score. But let’s discuss that point, and another perhaps more important issue that can be associated with either a short sale or a foreclosure.
Table of Contents:
What is a Short Sale?
A short sale takes place when a house is sold for less than the amount of debt owed on it. That’s the simplified version, and there’s a lot more to it.
It’s generally assumed that a home will ultimately be sold for more than the amount owed on it, but that’s not always the case. When you sign the mortgage papers at the closing on your 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.
So far so good.
But in the case of a short sale, the property seller is distressed. He or she can no longer afford to make the monthly payments. And not only is the property value less than the amount of the loan owed on it, but the seller has no personal assets available to make up the deficiency.
The distressed homeowner needs to sell the property to avoid foreclosure. A short sale, if it can be arranged, is generally better than a foreclosure. With a short sale, the property seller can arrange a more graceful exit. That is, she can stay in the property until it’s sold. And there are fewer add-on fees that typically come with 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, any contract offer on your home must be approved by the lender.
Naturally, the lender will be more likely to accept a contract that will come closer to paying off the entire mortgage balance. If the lender will take too big of a loss, they may decline the contract offer and the short sale.
As a result of the back-and-forth negotiations with the lender, it can take many months – and several failed attempts – before a short sale can be completed. In addition, the lender may opt in favor of foreclosure if it’s believed it will result in a smaller loss.
What is a Foreclosure?
A foreclosure is a legal process a lender implements when the borrower defaults on a mortgage. It typically occurs after a certain number of monthly payments have been missed. Exactly how many payments will depend on the laws in your state of residence.
Since 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
There’s a process involved, in which the lender must first serve you with a notice of default. You’ll generally be given a certain amount of time to correct the default, or the lender will implement foreclosure proceedings.
If the lender is in control on a short sale, that 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, in which the lender does not need to go through the courts, and can foreclose after a series of notifications. (The process is usually much quicker in nonjudicial foreclosure states.)
Once foreclosure takes place, the property will be seized by the sheriff and the occupants will be forced to evacuate. As the new owner of the property, the lender will either auction the property on the courthouse steps, or place it on the market for sale to satisfy the outstanding mortgage balance.
Whether a home is sold through a short sale or seized in a foreclosure, there will be consequences.
Short Sale vs Foreclosure: The Effect of Each on Your Credit
As you might expect, either a short sale or foreclosure will have a negative – even devastating – effect on your credit.
Just having 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 more long-lasting effect.
According to the website 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. But for a short sale with a deficiency balance or a foreclosure, it can fall as much is 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.
But even as your credit score increases, either a short sale or foreclosure can still have a negative impact.
For example, you will be required to wait a minimum of two years after a foreclosure or short sale before applying for a new mortgage. That guideline applies to both conventional and FHA mortgages.
However, 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.
Also, there are other types of loans, particularly credit cards, where you’ll be declined 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 the debt that’s written off 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 with the bankruptcy route, of course, is that you will now have both a foreclosure and a bankruptcy on your credit report. It will take many years for your credit score to recover after the combination. For that reason, it might be best to file for bankruptcy and include your house in the proceedings, rather than first facing a foreclosure.
A second option – at least as far as avoiding the tax liability of a mortgage deficiency – is an exemption under the Mortgage Forgiveness Debt Relief Act of 2007. It currently applies to mortgage deficiencies incurred through 2017, but has been renewed annually by Congress.
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 CPA, particularly if the amount is large.
What is better, a Short Sale or Foreclosure?
As you can tell from this discussion, the difference between a short sale and foreclosure is mostly cosmetic.
Either can destroy your credit 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. But on a more substantial note, a short sale will give you a better chance of vacating your home on your own terms, rather than through a sheriff 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.