If you’ve been unable to make mortgage payments, or in the case of an underwater mortgage, you have two main options: short sale or foreclosure. In both cases, you’ll have to let go of your home, but each option's consequences are different.

Understanding the difference between short sale vs. foreclosure will help you determine which option is right for you. In a short sale, you may be responsible for paying any deficiencies, but the negative impact on your credit score is less than what a foreclosure will cause.

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 on $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 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 Foreclosures?

Homeowners will need to give up their property in both short sale and foreclosure, but that’s the only similarity between the two options. Understanding the differences between short sale vs. foreclosure will help you decide which one may be right for you.

With a short sale, you will have more control over the process as a borrower. The mortgage lender initiates foreclosures, so you’ll have no control. Short sales can be quite lengthy and require a lot of paperwork, while sales usually happen quickly in foreclosures.

Short SaleForeclosure
Credit score drop not as significantSignificant drop in credit score and stays on credit report for seven years
May have to pay tax on debt forgivenessNo tax consequences
The lender forgives the deficiency in a short saleThere may be a deficiency judgment, where you’ll have to repay the remaining balance
Closing costs can be negotiated with the buyerYou’ll be responsible for paying the closing costs
The lender will only approve a short sale if the home value has dropped and you have financial hardshipForeclosure is 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 to be a riskier 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 negatively 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 the negative mark drops.

Financial Consequences

There are no tax consequences from a foreclosure for the borrower, but you may have to pay taxes on the debt forgiveness 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 a short sale, on which you may have to pay taxes.

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 must show that the home value has dropped.
  • Your mortgage should be in or at high risk of default.
  • You must demonstrate financial hardship to show why you can’t pay the difference.
  • You have no other assets you can use to pay the shorted difference.

How Short Sales and Foreclosures Work for Buyers

If you’re a buyer, it is essential to consider the key differences in how short sales vs. foreclosures work when it comes to purchasing a distressed property.

Short Sale Process

Purchasing a short sale property may provide you with a good investment opportunity and minimize the financial repercussions involved in purchasing a property if it went into foreclosure. However, the buying process can be lengthy and complex.

There are several ways to look for short sale homes, such as on Facebook Marketplace, Craigslist, and other social media platforms, which are often used by real estate professionals as well as homeowners. You can also work with a realtor to find a property that meets your needs.

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 works:

  • Start by presenting your case to the lender to convince them to agree to a short sale. 
  • Consult 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 Process

Purchasing a foreclosed property is complex and may not be for everyone. Lenders try to recoup as much money as they can to cover the balance owed on the home. In many cases, distressed homes are offered as-is, and you may not get a chance to get 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 FannieMae HomePath and Freddie Mac HomeSteps websites.

Here’s how the foreclosure process works:

  • If you’ve missed three to six mortgage payments, you’ll receive a Notice of Default.
  • You can pay the amount specified in the notice to stop the foreclosure process.
  • You also have the option to convince the lender for a short sale during this preforeclosure process. 
  • If you can’t repay the amount in the specified time, the lender will send you a Notice of Sale.
  • Your home will be auctioned on the date specified in the notice.
  • Following the auction, you’ll have to take your belongings and move to a new 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.

If you’ve missed a few mortgage payments and have received a Notice of Default, you’ll have to act fast. Consult an attorney and a real estate agent to explore your options for a short sale to avoid foreclosure.