By Janet Berry-Johnson, CPA, CPA
If you’d asked most U.S. homeowners in 2005 to define a "short sale," there’s a good chance they wouldn’t have an answer. Few homeowners had dealt with a short sale – the process of selling a home for less than what they owe on the mortgage – before the housing market crash of 2008.
But just three years later, more than one-third (38.6%) of single-family homes in the U.S. were considered distressed sales, including bank-owned properties, third-party foreclosure auction sales, and short sales. A decade later, distressed sales account for 14% of all single-family home sales in the U.S.
If you are having trouble making your mortgage payment, the fact that short sales are less common than they once were is likely cold comfort. Unfortunately, a short sale will negatively impact your credit score, but the question is by how much.
The short sale's effect depends on a number of factors, and you may be able to get into a new home faster than you think. Let’s look at what a short sale means for you and your credit.
As mentioned above, a short sale is a process in which a homeowner sells their home for less than what they owe on the mortgage. Once the sale is finalized, the seller ends up “short” of the amount they need to pay back the total loan.
The lender agrees to accept the lower sales price to avoid having the home go into foreclosure, which is a costly and time-consuming process. Lenders usually require the seller to prove financial hardship before approving a short sale.
You may be surprised to learn that the term "short sale" will not appear anywhere on your credit report. According to Experian, your credit report will indicate a "negotiated settlement" of your mortgage for less than you owe.
The immediate credit damage of that negotiated settlement will depend on a number of factors including your prior credit history and whether you were behind on your mortgage payments before the sale.
FICO studied how mortgage delinquencies such as late payments, short sales, and foreclosures impact credit scores. They used three hypothetical consumers with credit scores of 680, 720, and 780. The 2011 study found that the consumer with the highest credit score saw the biggest hit to their FICO score, with a drop of up to 160 points. Meanwhile, the credit score of the consumer with a lower starting score dropped by only about 100 points.
But the mortgage itself isn’t the only account that will impact your credit score after a short sale. After the settlement is reported to the credit bureaus, your credit card companies may lower your credit limits. This happens because the credit card companies see the negotiated settlement as a sign that you’re having financial troubles and want to limit their exposure in case you stop paying your credit card bills. Unfortunately, the reduction in credit limit also increases your credit utilization percentage, which is a factor your credit score (lower is better).
Whatever the immediate effect of the short sale, the negotiated settlement will stay on your credit report for seven years. However, the impact of the short sale will diminish with each year that goes by because recent credit actions have a bigger impact on your credit score than events from the past. In fact, if you work on rebuilding your credit, you may be eligible for a new mortgage in as little as two years, according to Fannie Mae.
Whether or not you’re interested in buying a new home right away, you should work to rebuild your credit and credit score. Not only will this improve your chances of getting approved for a new loan when the time is right, but it will also help ensure that you are financially capable of handling loan payments when the time comes.
Here’s how to get started rebuilding your credit after a short sale.
The FICO study mentioned above also looked at how long it takes for a person’s FICO score to recover after a short sale. According to their research, “while a score may begin to improve sooner, it could take up to seven to ten years to fully recover, assuming all other obligations are paid as agreed.”
A short sale is a viable alternative to foreclosure, but it’s not the only solution if you can’t afford your mortgage. You should investigate all available options before deciding which course of action you will take. Here are some alternatives.
The right solution for you depends on a number of factors, including your overall financial situation and your lender’s willingness to negotiate. Before you take action, it’s a good idea to get professional advice from your accountant, lawyer, or a HUD-approved housing counselor.
For people having trouble making their mortgage payments, a short sale offers many benefits over a foreclosure. The waiting period for getting a new mortgage after a short sale is typically shorter than the waiting period after a foreclosure (seven years, according to Fannie Mae), and you may qualify for cash relocation assistance.
Your credit rating will take a hit after a short sale, but you can take action right away to start rebuilding your credit score and improving your financial situation.
Janet Berry-Johnson is a Certified Public Accountant and personal finance writer. Her work has appeared in numerous publications, including CreditKarma and Forbes.