Difference Between Short Sale and Foreclosure

Homeowners typically buy a house by taking a mortgage for which the house functions as a collateral. The homeowner is expected to make timely mortgage payments, failing which, the house is seized by the lending institution. The real estate market crashed in 2007 and resulted in a number of people defaulting on mortgage payments. The reason for defaults could be attributed to the fact that the borrowers were sub prime and their only chance of repaying the borrowed amount hinged on their ability to refinance the home at a lower rate of interest. Another possibility was selling off the house in an upmarket and thus encashing the built up home equity. This hope was thwarted since the home owners were unable to sell off the home for a profit on account of the housing market crash. Rising interest rates and declining home prices resulted in defaults. In fact, many borrowers were unable to pay the taxes imposed by the Federal and the State government and became an easy target for tax lien foreclosures.

Short sales, in the context of real estate, refers to selling off a house at a price which is insufficient to meet the mortgage payments still owed on the house. In this case, lenders may be willing to accept the proceeds of the short sale as settlement for the money due and forgive the remaining amount that cannot be requited. The reason why a lender may be willing to accept a lower payment, than what is actually due, is to avoid lengthy and costly foreclosure proceedings.

Foreclosure Vs. Short Sales

Given that the government is providing assistance to homeowners to stop a foreclosure, short sales seems like a better option. According to Fair Isaac corporation, both foreclosures and short sales have the same level of negative impact on credit scores. They result in credit scores declining by 200 to 300 points. However, significant differences exist between short sales and foreclosures. The points of difference between short sale and foreclosure can be summarized as follows:

Waiting Time: In case of lenders complying with Freddie Mac and Fannie Mae guidelines, the borrower needs to wait for 5 years after completion of a foreclosure to avail a new mortgage, subject to establishing the desired credit score. Whereas in case of short sales, the waiting period is only 2 years.

Benefits to the Borrower: On February 18th, 2009, the Obama Administration announced the Making Home Affordable (MHA) Program. This program aims to stabilize the housing market by reducing mortgage payments, on both primary and secondary mortgages, to affordable levels, thus preventing avoidable foreclosures. Borrowers, who are unable to retain their homes despite being covered under MHA, may opt for short sales as an alternative to foreclosure. Under this plan, the homeowner may get up to $1,500 as relocation expense after short sales. Moreover, the seller does not have to pay taxes on forgiven debt provided the property that was sold was his primary residence.

Benefits to the Lender: Under the Making Home Affordable Program, lenders are encouraged to modify distressed loans to ensure affordable payments. As an extension of this program, lenders can also receive incentive payments up to $1,000 even if the homeowner's loan is not modified, provided short sales are allowed.

Hence, in the current scenario, a short sale is much better than a foreclosure. However both foreclosures and short sales will force the borrower to work at building his damaged credit history. According to Freddie Mac and Fannie Mae guidelines, assuming that the seller intends to buy a home some time again in the future, he would require a minimum FICO score of 680 for loans. FHA insured loans would require the borrower to have a credit score of 580 for the purpose of getting a mortgage after foreclosure.