Turbo Takeaways
- Homeowners who can’t pay their mortgage enter into foreclosure or complete a short sale.
- Short sales are initiated by the consumer, while foreclosure is dictated by the lender.
- Purchasing a short sale or foreclosure may offer benefits to both sellers and buyers.
Short Sale vs. Foreclosure: What Are the Differences?
If you’ve been unable to repay your mortgage debt due to a job loss or financial hardship, you may be looking for ways to save your home. When you fall behind on your mortgage payments, your property may become distressed, and you can either opt for a short-sale transaction or allow the bank to foreclose the property.
Here’s what each of these options may mean for you:
What Is a Short Sale?
A short sale transaction happens when you owe more on the mortgage than the property's market value when you want to sell it. A short sale involves asking the mortgage lender to accept a lower amount than the balance on your mortgage.
For example, if your outstanding mortgage balance is $350,000 and you sell it for $300,000, you’re short $50,000 on paying back the lender. If the lender accepts the short sale terms, you’ll sell the home through a real estate agent and settle the loan debt for the amount your home sells for. The lender will then release you from any further liability.
What Is a Foreclosure?
Foreclosure is a legal process that happens when a borrower cannot make mortgage payments for a significant amount of time. The lender will first issue a Notice of Default when you’re at risk of foreclosure, which usually happens after three to six months of missed payments.
You can try to settle your debt at this time through a short sale or by paying what you owe during the pre-foreclosure period, which lasts up to 120 days after you receive the notice.
If you’re unable to pay, the lender will step in and foreclose on the home because they have a lien on it. They’ll schedule a foreclosure auction to sell the property to try to recoup the amount you owe. If they’re unable to sell the property, it becomes bank-owned.
How Does a Short Sale Differ From a Foreclosure?
Homeowners will need to give up their property in both a short sale and a foreclosure, but that’s the only similarity between the two options.
With a short sale, you'll have more control over the process as a borrower. In contrast, a foreclosure is initiated by the lender, giving you little to no control, though the sale of the property typically happens faster.
Here’s a quick side-by-side of how short sales and foreclosures differ:
| Short Sale | Foreclosure |
|---|---|
| Credit score drop not as significant | Significant drop in credit score that stays on credit report for seven years |
| May have to pay tax on debt forgiveness | No tax consequences |
| Lender forgives the deficiency | May be a deficiency judgment to repay remaining balance |
| Closing costs can be negotiated with the buyer | Responsible for paying closing costs |
| Lender approves short sales if home value drops and owner shows financial hardship | Foreclosure initiated by the lender |
“Neither one of these options is what anyone wants,” shares Teresa Dodson, debt expert and founder of Greenbacks Consulting.
“Look at all of your other debt obligations first, like unsecured credit card debt. Try to negotiate a lower interest rate, secure a lower monthly payment, or use debt settlement to reduce your monthly expenses so you can keep your home,” Dodson explains.
Impact on Credit
With a short sale, you’ll see a drop in your credit score, and lenders will consider you a risky borrower. However, the credit score drop isn’t as significant as a foreclosure. In many cases, you may be able to purchase a home soon after a short sale if you meet the mortgage requirements.
Foreclosure can significantly impact your credit score and will stay on your credit report for seven years. It may be difficult for you to qualify for a new home loan in the future until your credit improves.
Financial Consequences
In a foreclosure, there are no tax consequences for the borrower, but you may have to pay taxes on any forgiven debt in case of a short sale. If your home sells for less than what you owe on the mortgage, the lender forgives the deficiency.
In case of a foreclosure, the lender may try to get a deficiency judgment to recover the remaining home loan balance after the sale of your foreclosed home. You’ll also be responsible for paying all closing costs in a foreclosure. In a short sale, the seller and buyer can negotiate who pays the closing costs.
Eligibility Requirements
Mortgage lenders initiate foreclosures, so there are no eligibility requirements. The pre-foreclosure process starts after you’ve fallen behind on mortgage payments for three to six months.
If you want to pursue a short sale, you’ll need to meet a few requirements to get lender approval, such as:
- Comparable sales showing the home value has dropped
- Mortgage at high risk of default
- Financial hardship proving you can’t pay the difference
- No additional assets to pay the shorted difference
How Short Sales and Foreclosures Work for Buyers
If you’re a buyer, it's essential to consider the key differences in how short sales and foreclosures work when it comes to purchasing a distressed property.
Short Sale Purchase
Purchasing a short sale may offer a good investment opportunity and minimize the financial repercussions associated with buying a property in foreclosure. However, the buying process can be lengthy and complex.
Look for preapproved short sales where the lender has approved the property’s sale price. Once you find a property you like, you can negotiate the sale and present an offer. The lender can then accept or reject the offer.
Here’s how the process of buying a short-sale home works:
- Start by presenting your case to the lender to convince them to agree to a short sale.
- Consult with a real estate agent, attorney, and tax professional.
- Set a selling price for the property.
- Gather the necessary documents to prove financial hardship to the lender.
- Find a buyer for the property.
- Submit your proposal to the lender.
Foreclosure Purchase
Purchasing a foreclosed property is also a complex process. Lenders attempt to recoup as much money as possible to cover the outstanding balance on the home. In many cases, distressed homes are sold as-is, and you may not have the opportunity to conduct a home inspection or tour the property.
Read the listing details carefully before purchasing a property because some foreclosures may require cash payments upon purchase. You’ll be able to find distressed properties on the Fannie Mae HomePath and Freddie Mac HomeSteps websites.
Below is how the foreclosure buying process works:
- Determine if the home is bank-owned, up for auction, or in pre-foreclosure.
- Work with a licensed real estate agent to manage property transactions.
- Determine the sale price and get preapproved for a mortgage.
- Carefully consider if any issues with the home make it not worth purchasing.
Challenges of Buying a Foreclosed Home
If you purchase a foreclosed home through a bank or auction, you may have to take the house without seeing the inside or completing an inspection. Make sure this is a risk you're willing to take before seriously pursuing a foreclosed home.
Do Short Sales and Foreclosures Change by State?
Each state has its own foreclosure laws that determine the process. Depending on state laws, the foreclosure process can be conducted through a non-judicial or judicial system. For example, in California, foreclosures are generally handled out of court, which can take about four months.
Court foreclosures occur only when a lender wants a deficiency judgment. This gives the borrower up to a year to redeem the property in question after the foreclosure sale. California is also one of the few states where deficiency judgments are prohibited on an approved short sale.
Short Sale vs. Foreclosure: Which One Is Right for You?
A short sale is better for borrowers if the lender agrees to the terms. Homeowners can sell the property to repay what they owe without a major impact on their credit score. However, buying a home in pre-foreclosure can result in similar benefits for both the buyer and seller.
If you’ve missed a few mortgage payments and have received a Notice of Default, you’ll have to act fast. Consult with an attorney and a real estate agent to explore your options for a short sale to avoid foreclosure.
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