Short Sale or Foreclosure: Which is Better for Your Credit Score?

The worst of the housing crisis seems to be behind us. (After all, the number of foreclosures continues to fall.) But it isn’t all good news just yet.

What is a Short Sale?

The most recent data from CoreLogic, a real-estate research firm, found that short sales (where a home is sold for less than the mortgage and the bank accepts the loss) have increased from 8.1% of total home sales to 10.4% year over year.

The Short Sale Process

As you know, the short sale process involves a lender agreeing to a mortgage payoff that is less than the amount owed to them. The lender takes a loss and “forgives” what is still owed to them.

A short sale usually starts when someone in the household has gone through a divorce, unemployment period, medical emergency, death, or bankruptcy. The seller will need to prepare a submission to the short sale bank, which should include a letter of authorization, previous tax returns, payroll stubs, bank statements, and W-2s. Someone buying the short sale will write a short sale offer and seller can choose to accept.

The short sale process for buyer can be a hassle and require a lot of patience–buying a short sale home involves waiting for a short sale approval from the bank.

How does a short sale affect your credit?

Most consumers probably assume that opting for a short sale limits the damage to their credit. (After all, if you have a foreclosure on your credit history, you could remain in lenders’ penalty boxes for up to seven years, says Liz Weston, author of Your Credit Score: How to Improve the 3-Digit Number that Shapes Your Financial Future.)

But surprisingly, a real estate short sale can drastically impact your credit score, too. “Both events [a short sale and a foreclosure] can have substantial repercussions to one’s credit score and are treated as derogatory items by the FICO score,” says Frederic Huynh, senior principal scientist at FICO.

For example, if a consumer with a high credit score (720 to 780) short sells her house, her score could nosedive 125 to 160 points. If her score is only around 680, she could lose 70 to 105 points. In both situations, there is little difference between short sale and foreclosure. The deductions are basically the same as when a consumer goes through foreclosure.

Furthermore, it takes approximately the same amount of time after a short sale and after a foreclosure—seven years—for the person with a high score to restore her credit; if her score is lower to start with, it will rebound in about three years.

But why?

“Research has shown that consumers with a short sale are credit risks, and they are less likely to pay off their credit obligations as agreed,” says Huynh. This is corroborated by a recent FICO study that found that “one out of every two borrowers who experienced a short sale went on to default on another account within two years.”

So if you must have a short sale, is there anything you can do to limit its impact?

The bad news: There’s no way to make your credit score immune to short sale homes.

The good news: You might be able lessen the blow.

“If the lender reports the transaction to the credit bureaus as a short sale with a deficiency balance (usually difference between the sale price and what you owe), then the effect on your credit score is the same as if you’d gone through foreclosure,” says Weston.

But if a deficiency balance is not reported, the damage could be less. In some situations, a deficiency balance doesn’t exist. But if one does with your property, Weston offers this advice: “As you’re negotiating the short sale with the lender, one of the things you should try to secure is the lender’s promise that it won’t report a deficiency balance.”

In short, simply asking a favor of your lender could be the difference between your credit score dropping—or plunging.

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Published April 10, 2013 Updated: March 28, 2016
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