Short Sale vs. Foreclosure: What’s the Difference?

What Is a Short Sale?

A short sale occurs when you sell your home for less than the amount you owe on your mortgage. It requires your lender's permission, and may be necessary if you are upside down or underwater on the loan—that is, your mortgage balance exceeds the amount you can get by selling the house.

You might find yourself upside down on your mortgage because:

• Your outstanding loan balance has grown
• Your home value has decreased since you financed the property
• A combination of both

You may be required to pay the difference between the amount your home sells for and what you owe on your mortgage, or your lender may forgive this deficiency balance.

A short sale will show up on your credit report as a settled account for seven years and this negative information can impact your credit score significantly, particularly in the beginning.

Learn more: How Does a Short Sale Affect Credit?

What Is a Foreclosure?

Foreclosure is the seizure of a home by a lender or loan servicer after the borrower fails to pay their mortgage as agreed. Procedures and timelines differ according to state and local laws, but the process typically begins after you've gone 120 days without making a mortgage payment and takes an additional one to 12 months before you are forced to vacate and the home is offered for sale at auction.

Foreclosure is a serious negative event in your credit history, and it remains on your credit reports for seven years from the date of the first missed payment that triggered the property seizure. A foreclosure can significantly decrease your credit score, but its impact does decrease over time.

Some lenders refuse to issue mortgages to applicants with foreclosures on their credit reports; others will only consider applicants with a foreclosure only if a specific number of months or years have passed since the foreclosure occurred.

Learn more: How Does a Foreclosure Affect Credit?

Short Sale vs. Foreclosure

Short sales and foreclosures share several undesirable attributes:

• Both involve loss of your home
• Neither generates cash proceeds that can be used toward purchase of a new home
• Both have serious negative impacts on your credit scores

Here are some key distinctions between short sale and foreclosure:

Credit Impact

The extent and duration of harm to your credit scores tends to be less with a short sale than a foreclosure.

Part of the reason is that foreclosure typically begins after you've missed three mortgage payments, and often concludes only after several more delinquencies, each of which does significant harm to credit scores before the foreclosure itself appears on your credit reports.

A short sale, if conducted without missing any mortgage payments, is reported as a "settled" account, which will cause a drop in your credit scores, but one less severe than a foreclosure and the missed payments that trigger it.

Tax Consequences

An important consideration in a short sale and some foreclosures is deficiency—the difference between what you owe on your mortgage and the home's market price.

Example: If you owe $300,000 on your mortgage and the house sells for $275,000 the deficiency is $25,000.

In some jurisdictions, lenders can sue after a short sale to obtain a deficiency judgment, requiring you to pay the deficiency amount. The same is true in some locales under certain types of foreclosure.

You can negotiate to have the lender waive their right to a deficiency judgement (make sure you get it in writing if they do).

Note, however, that any deficiency amount forgiven by the lender may be considered taxable income. Either way, you may want to consult a lawyer or financial professional for guidance on handling the deficiency in a short sale or foreclosure.

Second Mortgages

Any loan in addition to your mortgage that uses your home as collateral, such as a home equity loan or home equity line of credit, typically will not affect foreclosure but it could complicate or thwart a short sale.

All lenders with a claim on the house must approve a short sale, and issuers of second mortgages, who often stand to collect nothing in a short sale, may withhold permission or demand a cash payment before releasing their claim.

Learn more: Can I Buy a Home After Foreclosure?

Alternatives to a Short Sale or Foreclosure

Here are some alternatives to a short sale or foreclosure that you may want to consider:

• Loan modification: If you want to stay in your house but are struggling to meet your mortgage payments, consider asking your lender or loan servicer for a loan modification. This arrangement reconfigures your existing loan to reduce the monthly payment, typically by lowering the interest rate and/or extending the repayment term. Loan modification often increases the total amount you'll pay over the life of the loan.
• Forbearance: If a short-term financial setback (income loss or an unexpected expense, for instance) is making your mortgage payments unaffordable, mortgage forbearance could buy you time to get back on track by reducing or suspending your payments temporarily. You'll need to demonstrate your hardship and spell out a plan for resuming regular payments, and you'll typically be expected to pay back payments you didn't make during the forbearance period within 12 months or less.
• Deed in lieu of foreclosure: If you've fallen behind on your mortgage payments and foreclosure is looking unavoidable, a deed in lieu of foreclosure could be a better option. In this arrangement, you agree to vacate your house by a certain date and time without resorting to the legal process required for foreclosure. In exchange, the lender agrees to release you from the debt remaining on the property. In some cases, the lender may also provide a "cash for keys" stipend that you can put toward new housing. A deed in lieu of foreclosure leads to the mortgage account being labeled "settled" on your credit report, much as a short sale would, and any forgiven debt amount could be considered taxable income.
• Bankruptcy: If your income is low enough for you to qualify in your state, filing for Chapter 7 bankruptcy can discharge you from mortgage debt and/or any deficiency judgment you're liable for following a short sale or foreclosure. Chapter 7 has even more severe consequences for your credit scores than foreclosure, and it remains on your credit report for 10 years from the date you file with the court.

Frequently Asked Questions

The Bottom Line

Short sales and foreclosures are not positive options if you can't pay your mortgage, as both involve loss of your home and significant negative consequences for your credit. If you're facing either, consider taking steps as soon as possible to begin rebuilding your credit, so that when you're ready to consider another home purchase, you can qualify for the best borrowing terms you can get. You can monitor your recovery by regularly checking your FICO^® Score^Θ for free from Experian.