Credit Q&A: Short Sales, Foreclosures and Your Credit Score

Question: The value of my home has gone way down and is now worth less than what I owe. A friend is recommending I do a short sale saying it won’t hurt my credit score as much as a foreclosure. Is that true?

It’s not surprising this question comes up quite often considering that over 11 million households (23 percent of all mortgaged homes), were underwater in the Oct-Dec 2010 quarter according to a report released by Corelogic. With so many consumers evaluating their options, it’s important to understand the difference between a short sale and a foreclosure, and how each option may impact your credit scores.

So, what’s the difference between a short sale and a foreclosure? Simply put, a short sale occurs when the lender agrees to accept less than the total amount owed on the mortgage loan. A foreclosure on the other hand, is the legal termination of all rights of the borrower as the owner of the home and the lender in essence repossesses the home. In a foreclosure, the estate becomes the absolute property of the lending institution.

[Featured Tool: Get your free Credit Report Card from Credit.com]

The presence of either a foreclosure or short sale on a credit report is considered negative by credit scores because it is predictive of future credit risk. Generally speaking, the impact on the score will be similar for both a foreclosure and a short sale.

The exact score impact of a foreclosure or a short sale will depend on several factors:

Any additional information being reported on the mortgage account being included in a foreclosure or short sale. (For example, any late payments associated with said mortgage account prior to the foreclosure or short sale and how recently those past due payments took place.)

The current credit profile of the consumer. How the consumer is managing all their other credit obligations (credit cards, car loans, student loan, etc.). Are these other bills being paid on time or have missed payment been reported on these as well? Are credit cards showing high balances?

The negative impact on a credit score appears more severe if a foreclosure or short sale is reported on a credit report that has little or no history of missed payments and/or derogatory information, and has low balances on active credit accounts. In these scenarios, the number of points lost can be 150 or greater. The impact may be less noticeable if there are any indications of high-risk behavior (missed payments, etc.) already being reported in the credit report. This is because the negative history is already impacting the credit score which will be lower as a result, reflecting that higher risk behavior.

Get matched with a personal loan that’s right for you today.

Learn more

The perception that a short sale will always have less impact on a credit score compared to a foreclosure is simply a credit score myth. Bottom line, the score considers both items to be negative, high-risk behaviors, so both options will have a negative impact on the score.

Have a credit related question for Tom? Post your questions in the comments below!

Image by Mike Licht, via Flickr