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

If you’re a homeowner who is unable to make your mortgage payments, you might be facing the potential of foreclosure. One common method of avoiding the foreclosure process is a short sale. What exactly is a short sale and how is it different from a foreclosure? Are there any reasons to choose one instead of the other? And are there any ways to avoid foreclosure besides short sales? The following piece will answer those questions and offer additional information helpful to those who have fallen behind on their mortgage payments.

Short Sale

A short sale occurs when a homeowner sells their home for less than what they owe on their mortgage. A mortgage is a type of loan that a borrower uses for purchasing real estate. What makes a mortgage unique is that it uses the property purchased as collateral to secure the loan. This kind of secured debt allows a lender to repossess the property used as collateral if a borrower falls behind on their loan payments.

When a short sale occurs, the lender takes a loss because they’re accepting a price that’s less than what the homeowner owes on the mortgage. This loss is called a deficiency balance and depending on the applicable state law, the mortgage lender can try to recover a deficiency judgment from the homeowner at the conclusion of the short sale process. 

Some lenders accept a short sale instead of moving forward with a foreclosure because short sales can result in smaller losses for the lender and/or a faster way for them to get rid of REO property (bank-owned property). 

Homebuyers have an interest in short sales because they can sometimes purchase real estate at a lower than normal sale price. A seller might choose to short sell their home because they can no longer afford their mortgage but they want to avoid a foreclosure. Note that it's different from a short payoff.

The Short Sale Process

Short sales can begin and proceed in a variety of ways. In some cases, homeowners will put their houses on the market with a short sale designation. Then once they get an offer, they’ll go to the lender to ask them to approve the short sale. Sometimes, this is the first time the bank learns that the homeowner is struggling financially.

In other short sales, the homeowner will approach the lender to request a short sale before they put their property on the market. This might occur if the lender has begun the foreclosure process and the homeowner wants to find alternatives to foreclosure.

Either way, before the short sale can go through, the lender must approve it. This will require the seller to do the following:

• Answer questions proving the seller’s financial situation

• Provide financial documentation to support the seller’s claim of financial difficulty

• Submit a letter of financial hardship explaining the need for a short sale

• Complete any other short sale forms as required by the bank

Lenders will also ask borrowers to work with them to determine whether there are any other options available to avoid a short sale or otherwise keep the sellers in their homes. But lenders aren’t doing this out of charity. Instead, it’s because a short sale guarantees that a mortgage lender will lose money, so before approving the short sale, they will want to make sure the borrower has exhausted all alternatives.

Additionally, the lender will appraise the property to determine its fair market value and see if the buyer’s offer is in line with the overall real estate market. This is important for them to decide if the buyer’s offer for the short sale is reasonable or not.They’ll then want a complete offer from the prospective buyer. This includes the buyer’s qualifications for financing, earnest money, and a purchase contract.

After the lender reviews the offer, they may accept it, reject it, or submit a counteroffer. The counteroffer can include conditions that the lender wants the buyer to meet before they will accept the offer. The counter will also explain that if the buyer meets those conditions, the bank is likely to approve the short sale.

If the bank approves the short sale, the buyer and seller will proceed in compliance with the conditions set out by the lender. Some of these terms may include having the buyers agree to pay for various costs that sellers normally pay for when selling a house, like the cost of repairs. 

The average short sale takes about 90-120 days to complete, although they can take up to a year or as little as a month.

Foreclosure

During a foreclosure, a bank will exercise its rights under a mortgage loan contract to take back a homeowner’s property because of a default. Once they get the property back, they’ll sell it, often at a public foreclosure auction. A default occurs when the homeowner is unable to make mortgage payments for several months in a row.

A foreclosure is similar to a short sale in that they both:

• Lead to the homeowner losing the home.

• Result in the lender losing money.

• Negatively impact the homeowner’s credit history, credit score, and ability to obtain a future home loan.

• Have the lender control important points of the process.

Short sales and foreclosure are different in several ways as well, including:

• Lenders and homeowners work together in a short sale, but in foreclosures, homeowners often fight the bank’s attempt to foreclose on their property.

• The negative impacts of a short sale - including the damage that this process does to a homeowner’s credit score and ability to enter into a new mortgage contract within a few years - are far less severe than those tied to a foreclosure. 

• Short sales are optional. No homeowner in financial distress has to go through a short sale if they don’t want to. But when a lender decides to start the foreclosure process, the homeowner has no choice but to accept it, fight the lender’s efforts, or negotiate an alternative solution to the foreclosure (like a short sale).

Keep in mind that many states allow the bank to move forward with its foreclosure procedures at the same time that a homeowner may be trying to sell their home via a short sale. If you find yourself in this situation, don’t ignore any bank letters or court papers that you receive concerning a foreclosure. Don’t assume the short sale will get approved by your lender and let your guard down during the foreclosure proceedings. A failure to respond to court documents may eliminate your ability to raise a successful defense to the foreclosure action if a short sale (or other alternative approach) falls through. 

While lenders may pause the foreclosure process while working with you to arrange a short sale, they understand that the deal might not be successful. This means that if no short sale occurs, they’ll resume foreclosing on your home.

When a Short Sale Is Better Than a Foreclosure

One of the biggest advantages of a short sale is that it doesn’t impact your credit score as significantly as a foreclosure would. If you want to buy a new home in the future, this is an important distinction.

A foreclosure will stay on your credit report for seven years. Depending on the type of mortgage you apply for, the foreclosure could prevent you from getting a new mortgage for several years. For example, there’s a three-year waiting period before you can get an FHA loan. And with Fannie Mae or Freddie Mac loans, the waiting period could be as lengthy as seven years. But if you have a short sale, you can often get a mortgage to buy a new home soon after the short sale is complete.

Another major advantage of short sales is psychological. Specifically, short sales empower homeowners to do something about their financial situation. By contrast, a foreclosure puts the homeowner on the defensive, trying to either fight the bank or find another alternative that will work for their unique circumstances, which might be a luxury barred by how fast the foreclosure process is moving along.

Finally, there’s the fact that sellers can often stay in their homes during the sale process. This isn’t an automatic advantage over foreclosures, as homeowners facing foreclosure can also stay in their homes until there’s an eviction following the home’s foreclosure sale. But in many cases, a short sale will take longer than a foreclosure would. This can provide extra time to save money to find a new place to live as well as save on living costs.

What To Consider When Selling a Home Through a Short Sale

Although short sales have some advantages over foreclosure, there are still several things to think about before starting the process. 

First, short sales can take some time to complete. The exact time frame will vary, but you must plan ahead, especially if the lender intends to foreclose on your home while working with you to approve a short sale.

Second, the bank has the final say in the short sale of the property, not you. That’s because they’re the ones who have to take a loss on the sale.

Buyers and sellers of a short sale—and their representatives (like a real estate agent)—can handle many aspects of the home-buying process. But the most critical aspect of a short sale is that the lender must approve the terms of the buyer’s offer. The seller will be the one to present the lender with the buyer’s offer for short sale approval. 

The seller must also prove to the bank that they’re facing significant financial hardship and have no realistic chance of fully repaying the mortgage balance. Examples of financial hardship include prolonged unemployment or extensive medical bills. As a general rule of thumb, lenders are more likely to agree to a short sale when the homeowner has experienced a recent financial downturn as opposed to one that’s been around for a long time.

Third, unlike traditional home sales, the seller isn’t responsible for paying closing costs, realtor commissions, or other fees. Instead, the lender will likely pay these costs or pass them along to the prospective buyer. 

Fourth, when the sale price of the home doesn’t cover the outstanding mortgage loan balance, many states allow the bank to seek a deficiency judgment against the homeowner to recover the difference. A deficiency judgment can negatively affect the seller’s credit score in the same way a foreclosure can. It can also put you at risk of having your bank account or wages garnished 

To protect borrowers, many states have laws that prohibit deficiency judgments. But these laws only apply to deficiency judgments from foreclosures. So, if there’s a deficiency judgment from a short sale, the bank can go after the borrower for the difference. One exception is California, where deficiency judgments in short sales are also unlawful. 

If there’s no deficiency judgment because the bank cancels the remaining mortgage debt after the short sale, the homeowner will need to report that write-off on their taxes. This doesn’t mean that the homeowner will necessarily have to pay taxes on the canceled debt but it must still get reported to the IRS. Canceled mortgage loans up to $750,000 (or $375,000 for married people filing separately) carry no additional tax burden to the homeowner under the Mortgage Forgiveness Debt Relief Act of 2007.

Alternatives to Short Sales

For many homeowners, short sales are preferable to foreclosures. But a short sale isn’t always possible or may not be desirable for those who want to stay in their home. Luckily, there are other options available to assist a homeowner in keeping their home and avoiding foreclosure. They can try to modify their mortgage loan with their lender or take advantage of one of the many local and federal programs available to help people stay in their homes.

Homeowners who want to walk away from their homes without finding a buyer can consider a deed in lieu of foreclosure. A deed in lieu allows a homeowner to transfer the deed of their home to the mortgage holder, like a bank or mortgage company. In return, the homeowner gets released from the mortgage debt. Banks are generally more willing to accept a deed in lieu of foreclosure when there are no other liens on the property aside from the original mortgage.

Then there’s filing for bankruptcy. This opportunity can release a homeowner from the burden of other debts unrelated to the mortgage, but most importantly, it offers something called an automatic stay. This temporarily stops creditors and lienholders (such as mortgage lenders) from engaging in debt collection activities, like foreclosing on a property. This temporary reprieve can help you buy time to find another place to live or decide what approach to take when attempting to remain in your home. If you file for Chapter 13 bankruptcy, you may be able to pay off your outstanding debt over the life of your bankruptcy repayment plan, allowing you to remain in your home.

Lastly, you can talk to a local housing counselor who will work with you and your lender to find the best solution for your situation. This could include finding a way to stay in your home, deciding whether to file Chapter 7 or Chapter 13 bankruptcy, or looking into other debt settlement options.

Let’s Summarize…

Short sales have several benefits over the foreclosure process. These include a smaller hit to your credit score and the ability to take a more proactive role in what happens to your home. The diminished impact on your credit score is especially helpful if you hope to buy a new home in the foreseeable future.

But there are also drawbacks, such as the complicated procedures and paperwork you’ll need to navigate with your lender to have a short sale approved. If you need help figuring out the short sale process, you can work with a HUD-approved housing counselor or a local real estate agent or find a local attorney in your area who can help you manage the transaction.