How a Short Sale Could Affect Your Credit

If you’re a homeowner and you need to sell your home quickly to avoid foreclosure, you may be able to do a short sale. This article will explain what a short sale is and how it can help you find debt relief from a burdensome mortgage. It will also discuss how to repair your credit after a short sale and how to qualify for a new mortgage loan to buy a home in the future. Finally, we’ll talk about debt cancellation and what to do if a mortgage lender or servicer gets a deficiency judgment against you.

What Is a Short Sale?

A short sale happens when a home sells for less than the outstanding balance on the mortgage. It’s called a short sale because the sale proceeds fall short of the full amount of the mortgage loan. Short sales allow homeowners to avoid foreclosure and escape a situation where they owe more than their homes are worth. If you want to avoid the foreclosure process and you don’t qualify for loss mitigation options like a loan modification, a short sale could be your best alternative.

Since the proceeds from a short sale aren’t enough to cover the total amount due on the mortgage loan, the homeowner:

• May be legally liable for the difference. Depending on your state’s laws, the creditor may be able to get a deficiency judgment to pursue you for this shortfall once the short sale process is complete. 

• Must get the lender’s approval to do a short sale. Your lender may agree to a short sale if it determines the short sale is less expensive and time-consuming than a foreclosure. 

The best-case scenario would be for the lender to accept the sale proceeds and not pursue you for the shortfall.

Once a lender approves a short sale, the homeowner is responsible for completing the normal steps of the home-selling process. This includes hiring a realtor and getting the home ready for sale. One difference from a regular sale is that only the lender has the right to accept or decline offers. Once the lender accepts an offer, it receives all of the sale proceeds. 

As mentioned, when the proceeds of the sale don’t cover the balance of the mortgage debt, there’s a deficiency. The lender may forgive this deficiency amount. But as the homeowner, you need to make an agreement with the lender not to be held liable for any remaining loan balance after the short sale.

Do You Have To Pay the Deficiency After a Short Sale?

Most states allow lenders to pursue a deficiency judgment after a short sale. Only a few states prevent lenders from pursuing a borrower for the deficiency. Other states only allow deficiency judgments in certain instances. In Arizona, lenders can't purchase deficiencies for one- or two-family homes on 2.5 acres of land or less. And in North Dakota, mortgage lenders and servicers can seek deficiency judgments but typically not for owner-occupied homes.

Some states like Alaska, California, Minnesota, Montana, Oregon, and Washington prohibit deficiency judgments in most cases. In California, lenders may not pursue a deficiency judgment after foreclosing on any loan (a “purchase-money loan”) that was used to purchase the property. Almost all home loans consumers use are purchase-money loans. It doesn’t matter if the loan is a first, second, or third mortgage, or a home equity line of credit, there is no deficiency permitted after foreclosure.

A lender can begin attempting to collect the deficiency immediately after the short sale closes. It may pursue the deficiency itself or hire a collection agency to pursue the debt. Some lenders, as a condition of approving the short sale, require borrowers to sign a new promissory note for repayment of the deficiency. The lender may also include a clause in the short sale agreement that allows it to bill the borrower for the deficiency.

Hopefully, your lender will agree to approve the short sale and waive the deficiency. Though this is the best-case scenario, it may have tax consequences. That’s because the IRS considers the canceled debt to be income. Any debt forgiven after a short sale can result in taxable income and increase your taxes. But you will likely still come out ahead if your debt is canceled. This is because the increase in your income taxes will be a fraction of the total amount that you owed on the mortgage. It will also be much less than the amount of debt forgiven. 

What Impact Will a Short Sale Have on Your Credit Report?

Having a short sale on your credit report will damage your credit. When a short sale occurs, the credit bureaus typically mark your mortgage loan account as "settled," "not paid as agreed," or "account legally paid in full for less than the full balance." All of these reflect poorly on your payment history since it often shows you didn’t make the payments on your mortgage as agreed. 

Your payment history is one of the most important factors of your credit score, which is why a short sale could negatively impact your credit score. That said, some mortgage lenders view a short sale less negatively than a foreclosure because the borrower has partially repaid the mortgage.

How much will your credit score change as a result of a short sale? This depends on:

• The other information in your credit report,

• The scoring model used (FICO and VantageScore are most common),

• If you had missed or late payments prior to the short sale, and

• Whether the lender reports the deficiency from the sale. 

If the mortgage lender or servicer reports the deficiency, the short sale’s impact will be similar to the effect of a foreclosure or deed in lieu of foreclosure. If the lender doesn’t report the deficiency balance to the credit bureaus, your credit score may not drop as much as it would with a foreclosure. Also, if you didn’t miss any of your monthly mortgage payments before the short sale your credit score won’t be as impacted. There are always late or missed payments leading up to a foreclosure, which is why it can do such damage to your credit score.

The actual effect of a short sale on a credit score is different for each borrower. Since a credit score can drop by 100 to 150 points or more after a foreclosure, a short sale’s effect could be similar. If you have good credit before the sale, you may experience a larger hit to your score than someone with a lower score.

A good way to minimize the negative effects of a short sale on a credit report is to continue making timely monthly mortgage payments before and during the short sale process.

How Long Before You Can Qualify for a New Mortgage Loan?

Like a foreclosure and other negative entries on your credit report, “settling” your mortgage debt by doing a short sale will remain on your credit report for up to seven years. It will also affect you as a home buyer in the years following the short sale. 

In many cases, a short sale will significantly damage your credit less than foreclosure or bankruptcy since it may only prevent you from getting approved for a new home loan for two to three years. After three years, you may be able to qualify for an FHA loan. Foreclosure or bankruptcy can prevent you from buying a new home for several years, depending on the type of mortgage. Filing bankruptcy will help you find debt relief since you can discharge credit card debts, personal loans, medical bills, and other unsecured debts.

Filing a bankruptcy case after a short sale will allow you to discharge any deficiency that results from the short sale. Upsolve has a free application that can help you file bankruptcy on your own without an attorney. If you need an attorney to file bankruptcy, most bankruptcy attorneys offer free consultations. 

While you wait to purchase another home, you can focus on repairing your credit and improving your credit score. Recent activity demonstrating good credit habits can improve your credit profile the next time that you apply for a mortgage loan. Lenders often put more weight on a consumer’s credit history in the 24 months preceding an application for new credit than on older items in their credit history. 

Start Rebuilding Your Credit Immediately

If there’s a major event like a short sale on your credit history, it may take time to rebuild your credit. Here are some important steps to take to repair your credit:

• Periodically review your credit reports for errors. Take advantage of the free credit reports available from AnnualCreditReport.com. If you find an error, dispute it immediately.

• Make timely monthly payments for bills, loans, and credit cards every month to maintain a good payment history.

• Make payments to reduce the balances of revolving accounts like credit cards and store lines of credit to help lower your credit utilization ratio. This is how much of your total available credit you’re using at any given time. It’s another factor that affects your credit score. Lenders prefer credit utilization ratios of 30% or less. 

• Open new credit accounts if you currently don't have any loans or credit cards. This will help build credit. Secured credit cards and credit-builder loans are good alternatives to consider.

• Add utility, cellphone, and streaming service payments to your credit file. ExperianBoost can report these payments to Experian, which will positively affect your Experian credit score.

Let's Summarize...

A short sale is the sale of a home for less than the outstanding balance on the home’s mortgage. A lender must approve a short sale. Since the proceeds of the sale are short of the mortgage balance, a short sale typically results in a deficiency balance. A lender may agree to waive this balance or pursue the borrower for it depending on state law. Most states allow lenders to pursue borrowers for the deficiency after a short sale.

Like a foreclosure, a short sale will generally have a significant negative impact on your credit score, but the negative effect could be slightly less than foreclosure in some circumstances. Fortunately, there are many ways that you can rebuild your credit during this waiting period that a short sale remains on your credit report. You should be able to qualify for a home loan in just a few years.