The Truth About Short Sales and Their Impact on Your Credit

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One of the most frightening titles you can own right now is “homeowner.”  That’s because millions of us have completely lost the equity in our homes, which means we are in the unenviable position of owing more than the home is actually worth.  Nobody asks for their home’s value to fall, but plenty of homeowners are now in the position of trying to dispose of mortgages that are considered upside-down.

There are several ways to do this.  First, you can actually find someone willing to buy your house for enough dough to cover all of the mortgages it secures.  NOTE: That’s probably not going to happen so proceed to Option #2.  Option #2 is to pay the difference out of your own pocket.  So, if you owe $150,000 and find a buyer at $125,000 you’d have to show up at closing with a check for $25,000 to cover the difference.  If that’s not an option then you can walk away from the home (foreclosure), turn the keys back over to the lender (forfeiture of deed in lieu of foreclosure), or attempt to have the loan modified and stay in the property. Finally, you can attempt to short sell the home.

A short sale is when the lender accepts less than the full loan balance and considers the loan to be paid.  So, in the aforementioned example, if the lender had accepted $125,000 as a full payoff then you would have been on your way to a successful short sale.  The lender would eat the $25,000 deficiency and everyone would call it a day.  But it’s not that simple.  There’s the impact this event will likely have on your credit.

Short sales are a relatively new phenomenon and because of this there’s an incredible amount of misinformation about the impact to your credit.  Some people are even going so far as to say that a short sale is neutral to your credit, which is incorrect.  Short sales are reported to the credit reporting agencies as either settlements or charge offs, both of which are accurate.  The lender is settling for less than you really owe, and they’re likely charging off the deficiency.

Some people, real estate agents in particular, have seized this reporting format as to mean that short sales are not reported to the credit bureaus at all simply because the words “short” and “sale” do not show up on your credit reports.  And, they’re using it to market the value of short sales as a benign event in an effort to drum up business.  Pretty much every reputable credit source acknowledges that short sales are just as bad for your credit as any other negative mortgage event, but just in case it’s at all unclear, I offer the following statements from the people who actually invented the FICO credit score:

From the Minneapolis Star Tribune – “Both short sales and foreclosures are considered negative by the score, because our data shows us it’s very predictive of future credit risk,” Tom Quinn, vice president of FICO scores at FICO (FICO), formerly known as Fair Isaac Corp.” The claim that doing a short sale is not going to hurt your score is false. It’s inaccurate.”

From American Banker – “To the FICO score, there is very little difference between a short sale, a deed-in-lieu or a foreclosure — and we’ve been saying that to anybody who will listen, but this rumor that short sales are somehow benign has persisted,” Craig Watts, a spokesman for Fair Isaac, the maker of FICO scores.

That should just about clear up any misunderstanding or misrepresentation of how a short sale impacts your credit.  It’s still a better option than a foreclosure because people trying to market their home for a short sale will still maintain the home’s cleanliness, mow the law, and won’t rip out the copper piping or appliances.  But, it’s still not a clean break between you and your mortgage lender.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and the author of the “credit history” definition on Wikipedia.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry.  He has served as a credit expert witness in more than 70 cases and has been qualified to testify in both Federal and State court on the topic of consumer credit.