Financial trouble can be disastrous for American homeowners. After missing four to five mortgage payments, a lender will typically foreclose on your mortgage. This puts you out a home and results in a hefty bad debt showing on your credit file. Meanwhile, a short sale is an “exit strategy” that lets you pay off as much of the debt as possible.
How a Short Sale Affects Your Credit
It is common knowledge that a foreclosure is bad for your credit score. But a short sale is an alternative that can reduce the amount you have to foreclose. Accomplishing this will require selling the home before the foreclosure takes place. When this is an option, it can result in much less bad debt showing on your credit report.
The short sale will still lower your credit score for a long time. This entry can stay on your credit report for up to seven years. You can lose anywhere from 85-160 points, depending on your current FICO score and the severity of your short close. The majority of your score drop will go away within two years if you sustain good credit otherwise.
No Late Payments on a Short Sale
Are you aware that you will be unable to pay for your mortgage in the near future? For example, you might be going through divorce procedures and realize that the home is too expensive for either party to uphold. It makes sense to do a short sale at this point, but what does it mean for your credit score if you avoid late payments?
The biggest benefit is that you will not have late payments on your credit report. Your first late mortgage payment can drop your FICO score by 90-110 points. The actual damage depends on your score before the late payment; for example, if your score is 730, this number could drop below 650 after your first missed payment.
Now, there are two problems that interfere with this happy ending:
- Sometimes You Need Late Payments
While not always the case, many lenders will require you to run late on your mortgage payments to qualify for a short sale. That requirement exists for FHA home loans, which need to be a minimum of 31 days late by the time the sale closes. Otherwise, FHA will not approve the transaction. This means you need to withstand the FICO score drop that comes with running late on a mortgage payment. Thankfully, this not a requirement if your mortgage is through Fannie Mae or Freddie Mac.
2. Your Home Has to Sell Pretty Fast
After 90 days or so, there will be more pressure to perform a “deed in foreclosure,” which works the same as a voluntary repossession. This entry factors into your credit report the same as a foreclosure, which means it is more harmful to your credit score than a short sale. Thus, your home needs to sell pretty fast or else the benefits of a short sale are minimal.
You can always take action to make the voluntary repo show better on your file. The main thing is to request the entry to show as “paid as agreed,” on your report. If the lender does not comply, you can then ask for it to be marked as “settled,” or “unrated.” These are all better entries than “foreclosure,” which is a reporting option for your lender.
How a Foreclosure Impacts Your Credit Score
A foreclosure is a more serious way of handling an unaffordable mortgage. You are giving up the debt and the lender must assume full liability. A short sale can let you capture on any real estate market gains to mitigate some of the losses. The remainder (“the deficiency”) is all you are left on the hook for, although some creditors will sue you in court for these funds.
But, with a foreclosure, you are effectively walking away from your mortgage in the most irresponsible way possible. There is no chance to determine the value of your home and the amount of bad debt becomes your entire mortgage balance. This means failing to short sell when running late on payments during a hot real estate market can be costly.
FICO Score Change from Foreclosing
You can expect your FICO score to drop by anywhere from 85-160 points depending on the specifics of your foreclosure. This typically happens when you run many months late, and by the time the debt closes, you will certainly have a 120-day late entry on your credit. This late payment entry holds longer than a single 30-day late payment; while a short sale will mostly age off after two years, a foreclosure will weigh your FICO score down for longer.
A foreclosure often comes with more serious financial struggles than a short sale, because short selling is pre-foreclosure and comes with foresight. Doing a short sale of your home can prevent you from going bankrupt at times. If your foreclosure pairs with a bankruptcy, your FICO score could drop by as much as 240 points.
Conclusion: Go for a Short Sale When Possible
The truth is that your score will suffer for at least two years, regardless of what you choose. The short sale will be less damaging, though, and it will not be as hard to keep building your credit as it would be after foreclosing on your home.
Remember that large FICO score drops occur from late payments, foreclosures and short sales alike. But it is the reporting terms that decide how severe the drop is and how long it takes to recover.