Is a Short Sale Better Than a Foreclosure?

Homeownership can lead to financial difficulties, making it challenging to meet mortgage obligations. When facing such distress, homeowners might consider a short sale or a foreclosure. These distinct processes resolve mortgage debt when a property owner can no longer afford their home. Understanding the characteristics and outcomes of each provides clarity for those navigating these complex situations. This article outlines the mechanics and implications of short sales and foreclosures.

Understanding a Short Sale

A short sale occurs when a homeowner sells their property for less than the outstanding mortgage balance, with the lender’s explicit approval. This option arises when a homeowner faces financial hardship, such as job loss, medical emergency, or divorce, and the property’s market value has fallen below the amount owed. The homeowner initiates this process to avoid the more severe consequences of foreclosure.

The process begins with the homeowner contacting their lender to explain the financial hardship and request a short sale. They must provide financial documentation, including income, assets, and a hardship letter, for the lender to review. Once the lender agrees to consider the short sale, the homeowner lists the property for sale.

Offers from potential buyers are submitted to the lender for review and approval. The lender evaluates the offer, considering the property’s value and potential loss, before deciding whether to accept a reduced payoff. If the lender approves, the transaction proceeds to closing, where the title transfers to the new buyer, and the lender accepts the agreed-upon lesser amount to satisfy the mortgage. This negotiation for debt forgiveness is a central aspect of the short sale process.

Understanding Foreclosure

Foreclosure is a legal process initiated by a mortgage lender to repossess a property when the homeowner fails to make agreed-upon mortgage payments. This typically begins after several missed payments, often three to six months of delinquency. This action allows the lender to recover the outstanding loan balance by taking ownership and selling the property that served as collateral.

The initial step is usually a notice of default, informing the borrower of missed payments and the lender’s intent to begin proceedings. This notice provides a reinstatement period, during which the homeowner may catch up on payments to halt the process. If payments are not brought current, the lender proceeds with legal action.

The legal process varies by state, requiring either a judicial or non-judicial foreclosure. Judicial foreclosures involve court proceedings to obtain a judgment, leading to a public auction. Non-judicial foreclosures, permissible in some states based on a “power of sale” clause, allow the lender to sell the property without court oversight. Following the sale, if the former homeowner has not vacated, an eviction process may follow to remove them.

Financial and Credit Implications

Credit Impact

A short sale typically has a less severe impact on a homeowner’s credit report than a foreclosure. While both appear as negative marks, a short sale is often viewed more favorably by credit bureaus and future lenders because it indicates a proactive effort to resolve financial difficulties. A short sale can result in a credit score drop of 100 to 200 points and generally remains on the credit report for seven years from the original delinquency date.

Conversely, a foreclosure carries a more significant negative impact on credit scores. It can lead to a substantial drop, potentially ranging from 250 to over 400 points. A foreclosure remains on a credit report for seven years from the filing date, making it more challenging to obtain new credit, especially future mortgages, for an extended period.

Deficiency Judgments

A deficiency judgment represents the remaining debt owed to the lender if property sale proceeds, from a short sale or foreclosure, are insufficient to cover the outstanding mortgage balance. In a short sale, lenders often agree to waive or reduce this deficiency as part of the approval. It is important for the homeowner to secure an explicit written waiver of the deficiency from the lender to avoid future liability.

In foreclosure cases, lenders are generally more likely to pursue a deficiency judgment. The ability to obtain such a judgment depends on state laws; some states have anti-deficiency statutes that protect homeowners. If a deficiency judgment is pursued and granted by a court, the homeowner remains legally obligated to pay the remaining debt, which could include legal fees and other associated costs incurred by the lender.

Tax Implications

When a lender forgives or cancels debt as part of a short sale or after a foreclosure, the canceled amount may be considered taxable income by the Internal Revenue Service (IRS). Lenders are typically required to issue Form 1099-C, “Cancellation of Debt,” to the homeowner and the IRS for any canceled debt of $600 or more. This form reports the amount of debt forgiven.

However, certain exclusions may apply, preventing the canceled debt from being taxed as ordinary income. For instance, if the homeowner was insolvent immediately before the debt cancellation, the forgiven debt may be excluded from income up to the amount of insolvency. Provisions may also allow for the exclusion of canceled debt on a primary home. Due to the complexity of tax laws and their potential for change, consulting a qualified tax professional is advisable to understand specific tax obligations and available exclusions.

Future Housing Eligibility

The ability to obtain a new mortgage after a short sale or foreclosure varies significantly based on loan type and time elapsed. For a new FHA loan, a waiting period of three years is typically required from the date of the short sale or foreclosure. Exceptions may apply for extenuating circumstances or if the borrower was current on payments before the short sale. VA loans generally have a shorter waiting period, often two years after a short sale or foreclosure, provided the borrower re-establishes credit.

For conventional loans backed by Fannie Mae or Freddie Mac, waiting periods are usually longer. After a short sale, a waiting period of two to four years may apply, depending on factors like loan-to-value ratio and extenuating circumstances. Following a foreclosure, the waiting period for a conventional loan is typically seven years from the completion date. This can be reduced to three years under certain extenuating circumstances and with a significant down payment. Re-establishing a positive payment history and credit after either event is important for future mortgage eligibility.