Understanding How a Short Sale May Affect Your Credit Score

Understanding How a Short Sale May Affect Your Credit Score

I receive calls weekly asking me what affect a short sale or foreclosure (or deed-in-lieu of foreclosure) will have on an individual’s credit. Unfortunately we hear such a variety of conflicting information; it’s hard to know who to believe or who is even handing out relevant advice.  What I will show you is the basics that the credit agencies have given out to date.

Short Sale Affect on FICO Scores

In the world of credit scoring, there are three major credit events that will severely impact your score, and they all carry an equal weight. They are listed as:

1. Serious delinquency
2. Derogatory public record
3. Collection filed

A homeowner in default (behind on payments) is technically in collection.

Facts about Short Sales and Credit Ratings

1. Credit preservation advantage for a short sale over foreclosure is limited if you have missed two mortgage payments in a row or more prior to the short sale finalizing.
2. The two largest mortgage investors, Fannie Mae and Freddie Mac — with few exceptions – will not lend again for four years (foreclosure) and two years (short sale).
3. Consumer’s credit score will take a hit until a consumer can re-establish good credit behaviors to supplant the foreclosure or short sale over a period of time.

The Rest of the Story…

The term Short Sale has become much more popular term this year due to the mortgage and credit meltdown. Short Sale is defined as selling your home for less than you owe the lien holder.  Many have questioned if this term Short Sale actually appears on a credit report, well it does not.  The most important concept to research and study is how the mortgage loan will be closed and reported in your credit history, before you agree to the terms your lender has to offer.

When you pay less than originally agreed on any loan or credit card, this will always impact your credit report negatively.  It is rare for a lender to report the mortgage as paid (or paid in full), and forgive the remaining amount owed on the loan. If that were to happen and assuming you had made all payments on time, your credit score would not be impacted.

Most often, however, a short sale is reported as settled (or settled for less), simply defined as you reaching an agreement to pay back only a portion of your outstanding balance.  The remainder is written off (or charged off) as a loss by your creditor.  Settled accounts much like charged off accounts, will be very negative, and even more so with a mortgage involved.

Previous to 2008, the remaining balance was considered as income for which you would owe taxes, and would report as a capital gain. Due to the number of mortgage crises this year, the IRS amended the tax code temporarily to waive this tax, and provide some comfort to those that are struggling.  As IRS codes will always be changing verify that is still true when filing your 2009 taxes.

When one decides to Short Sell it is usually to end the pain, the consequences in terms of negative impact on your credit if it was something you  could not control, learn from it and move on; take the time to start rebuilding your credit, which will be done through positive credit management. 

Buying a Home after a Short Sale

A foreclosure will remain on your credit report in the public records section for up to 10 years. You will notice that there is no question about a short sale.  If you have gone 120 days late on your mortgage, and your home was not foreclosed on, make sure you retain all the paper work.  As you try to take out a loan in the future you will need to provide proof that you sold the home rather than had it foreclosed on.  This is done via your closing statement or HUD-1.  The mortgage application under Section VIII currently asks the following questions:

1. Have you had property foreclosed upon or given title or deed in lieu thereof in the last 7 years? (Y/N)
2. Have you directly or indirectly been obligated on any loan which resulted in foreclosure, transfer of title in lieu of foreclosure, or judgment? (Y/N)

Actually, the decision makers in the mortgage industry know that a short sale is no different than a foreclosure or deed-in-lieu.  In all cases, the debt was settled for less than was owed.