If you fall behind on your mortgage payments or if your mortgage is underwater, (the home is worth less than what you still owe on it.) you can either go through a short sale or a foreclosure.
Both situations require owners to give up their home. However, the process and financial effects are different, so it is important to know the pros and cons of each choice.
This post will give you a detailed look at the two main types of troubled property sales.
This way, you can make an informed choice if you need to sell your home quickly because of money problems.
What is a short sale on a house?
A short sale on a house refers to a situation where a homeowner sells their property for less than the amount owed on the mortgage.
This usually happens when the homeowner can no longer afford to pay down the entire mortgage balance due to a decline in the property’s value.
Since the sale proceeds won’t pay off the total mortgage debt, the homeowner requires authorization from the lender to proceed with a short sale. The lender consents to waive the outstanding balance and accept the sale price as complete payment for the debt.
Although they entail difficult negotiations and approval procedures with the lender, short sales can be an option for homeowners facing financial difficulties to prevent foreclosure and its detrimental effects.
What is a foreclosure?
When a homeowner defaults on their mortgage, the lender can legally take possession of the property and sell it. This process is known as foreclosure. Usually, it’s the lender’s last option to collect the outstanding balance on the mortgage.
When a homeowner misses mortgage payments, the foreclosure process often begins.
A notice of default is sent by the lender to the homeowner, allowing them to make up missed payments. The property enters foreclosure if the homeowner is unable to make alternate arrangements with the lender or bring the mortgage current.
Auctions are frequently used to sell foreclosure properties, with the money raised going toward paying down the mortgage. Depending on state regulations and the terms of the mortgage, the homeowner may still be liable for the remaining amount if the sale doesn’t cover the entire amount owed.
Homeowners who experience foreclosure may lose their house and see a decline in their credit score, among other major repercussions.
How is a short sale different from a foreclosure?
Homeowners in financial trouble have two options: a short sale and a foreclosure.
However, the ways in which these two approaches handle selling a home when the owner is unable to make mortgage payments are very different.
Let’s have a look at these differences.
Short Sale:
- voluntary process – In a short sale, the homeowner initiates the sale of the property. They work with the lender to sell the home for less than the amount owed on the mortgage.
- needs lender approval – the lender must approve the short sale because the sale proceeds won’t cover the full mortgage amount. The lender agrees to accept the sale price as settlement of the debt, forgiving the remaining balance.
- avoids foreclosure – a short sale is often seen as a proactive step to avoid foreclosure. It allows the homeowner to sell the property and settle the debt without going through the foreclosure process.
- impact on credit – while a short sale can still have a negative impact on credit scores, it’s generally less damaging than a foreclosure.
Foreclosure:
- involuntary process – the foreclosure process is involuntary for the homeowner because it is the lender that initiates the process.
- legal process – to collect the money owed on the mortgage, the lender must go through a legal process whereby they seize the property and sell it at auction.
- loss of ownership – when a home enters foreclosure, the owner forfeits possession and is required to leave the property.
- credit impact – foreclosure can negatively affect credit ratings and create long-term difficulties in obtaining loans or homes in the future.
What impact does a short sale have on your credit score?
A short sale can have a negative impact on your credit score, although typically it’s not as severe as a foreclosure.
Here’s how it generally affects credit scores:
- Credit score drop – short sales are reported to credit bureaus, lowering credit scores. The influence depends on credit history and other factors.
- Credit history – The short sale will show on your credit report that the property was sold for less than owed. This could stay on your credit report for up to seven years, impacting your credit history.
- Short term credit damage – a short sale can still affect your ability to secure new credit or loans in the short term because lenders might view it as a negative mark on your creditworthiness.
What impact does a foreclosure have on your credit score?
Your credit score is usually impacted by foreclosure. Some key effects are:
- credit score drop – a foreclosure can lower your credit score by hundreds of points. The scale of the impact depends on credit history and other factors.
- dents your credit history – a foreclosure can stay on your credit history for as much as seven years
- difficulty getting new credit – after a foreclosure, getting credit, loans, or mortgages might be difficult. The foreclosure on your record may make you a high-risk borrower.
- impact on future housing – because of the dent on your credit score and history, credit checks from your prospective landlords or mortgage lenders may make renting or buying a property more difficult for you
- long-term consequences – foreclosure might harm your finances and ability to borrow at good rates for years.
Why do banks prefer foreclosure to short sale?
Banks are businesses. And just like any business, they’re seeking to make the best out of any bad business situation.
Banks prefer a foreclosure to a short sale because of:
- profits – banks believe foreclosure will yield more than a short sale. They may think foreclosure auctions or post-foreclosure sales will generate larger returns than short sales.
- control – banks can have more control over the foreclosure process. When there is a short sale, they have to agree to the buyer’s terms and go through the negotiation process, which can take time and doesn’t always lead to a sale.
- credit considerations – while foreclosure and short sales affect banks’ finances, short sales affects a bank’s credit record more than foreclosure.
- legal considerations – some foreclosures are simpler than short sales, which can involve many parties and complicated legal paperwork.
Which is worse for your credit?
Foreclosures and short sales both hurt your credit in the long run, but foreclosures tend to be worse and last longer than short sales.
Short Sale vs Foreclosure: Final Thoughts
A short sale is when the lender agrees to let you sell the house for less than what’s still owed on the mortgage. On the other hand, foreclosure is when the lender takes back the house and sells it to collect the debt after the homeowner stops making payments.
Both choices have consequences, but a short sale is often seen as a more proactive way to lessen the financial impact than going through foreclosure.
It can take a long time and a lot of hard work to get your credit back after a foreclosure.
These are all important things you can do to slowly raise your credit score after a foreclosure:
- making payments on time
- lowering your debt
- using credit carefully
