Foreclosure vs Short Sale

If you fall behind on mortgage payments, you have a lot of options: but the list may be dazzling and confusing. Wish someone would just tell you what option would work for your situation? We’ll explore two main options, foreclosure and a short sale.

What is a Short Sale?

A short sale is a quick sale on a house that occurs when the homeowner owes more on the loan than the sale price of the house is going to fetch. Basically, a short sale means that you ask the lender to accept less money than they expected on the loan. If you have a house that you can sell for only 300k but the loan balance is 325k, then you have to ask the bank to accept a “short” sale in which you pay them back less than you took out.

Keep in mind that short sales only really work when the bank cannot leverage a deficiency judgment against the loan. In a deficiency judgment, a bank can seek to recover the loan difference (in our example, the 25k) after the short sale is over. You can’t do this in California if the borrower has used the loan for a primary residence—but it’s something to keep in mind.

What is Foreclosure?

Foreclosure is a process where the lender seeks to recover the home and the loan value from a borrower who has fallen behind on payments. Lenders typically issue a notice of default after 3 to 6 months of payments that are missed. After a 90 day period when the notice of default is issued, the lender can then move to take the house to auction and sell it themselves.

How Foreclosure and Short Sales Work for Lenders and Borrowers

As a borrower, you’re looking to avoid the highest costs and hits to your credit score. Avoiding both a foreclosure and short sale is obviously ideal, but if it is inevitable that you’re losing your house, then you’ll want the least painful process.

Banks and lenders, on the other hand, are just trying to recover the highest possible value on the house. If they are not going to get the full cost of the mortgage, then they want the most money possible. Banks will usually not reject the offer of a short sale unless the short sale is near the market value of the house. There are also usually laws that prevent banks from selling a house for more than the value of the mortgage, and in California law prevents banks from chasing down a deficiency judgment to recover extra money on top of the short sale.

Generally speaking, banks and lenders want you to make a short sale. Banks that take houses to auction probably won’t get a better offer than a short sale. But this depends on the state of the real estate market at the time. If banks feel like your house is worth a lot of money and they can recover their costs and then some, they may pursue foreclosure.

Who Can Authorize a Short Sale or Foreclosure?

Unlike foreclosure, a short sale must be agreed on by both parties. You cannot make a short sale of your house if the lender doesn’t allow it, and in no case can the lender force the borrower to make a short sale. Most lenders will allow a short sale to go through—it will probably recover more of their money, and it puts the burden of work on the borrower to sell the house.

Foreclosure, on the other hand, doesn’t require anyone’s authorization to go through. If you’re behind on payments the lender can begin the foreclosure process without your consent.

What Happens to a Credit Score?

Foreclosure is one of the worst things that you can have on your credit report, and it hangs around for seven years. Foreclosure makes it very difficult to get another house and another mortgage, unless you can prove that something substantial has changed. You definitely won’t get good rates, and you’ll be considered a very risky borrower in the future.

Short sales, on the other hand, don’t destroy your credit rating in the same way. You will experience a drop and will definitely be considered a riskier borrower. But you’ve shown a tenacity and ability to get out of a tough financial spot. Your credit score hasn’t dropped as much, and in some cases, you can get another home immediately.

Ultimately, if you’re a borrower, you should aim to make a short sale of your house to avoid foreclosure. It prevents your credit score from tanking in the same way.