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How Does a Short Sale Affect Credit?
August 23, 2020

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How Does a Short Sale Affect Credit?

Distressed home sales – bank-owned sales, third-party foreclosures, and short sales – accounted for 14% of all U.S. single-family home sales just a couple of days ago. Even though the number of short sales is going down, it’s still a common thing. If you are struggling to make your mortgage payment, it might be a viable option for you.

Does a short sale ruin your credit? This is a question that many homeowners have. The effect depends on a number of factors, and there are some things you can do to rebuild your credit faster. Let’s look at what a short sale means for you and your credit.

How Does a Short Sale Affect Credit?

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What Does Short Sale Mean?

A short sale happens when a lender forgives part of the debt owed against the home and accepts less than the original amount. When the house is sold, the lender receives the proceeds of the sale. However, the remaining loan balance may not be forgiven, and the lender can seek a deficiency judgment against you. This will mean that you will have to pay the difference.

How does a short sale work compared to a foreclosure? Foreclosure means that your mortgage lender can legally repossess your house and recover its costs by selling it. In a short sale, the lender doesn’t recover its outlay. But it’s considered a better option than handling all the difficulties that come with foreclosures.

Short sales are a mixed bag for both the lender and the seller. Lenders are most likely to take a financial loss, but it’s not as time-consuming as other alternatives. As a seller, you will deal with consequences for a long time, such as problems of where to live and credit damage.

It’s not easy to negotiate a short sale. Having professional assistance will be a tremendous help. It can also be helpful in negotiating what the lender will do with the unpaid balance on the mortgage.

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How a Short Sale Impacts Your Credit

We’ve talked about the short sale definition and how it works. As for your credit, there is, unfortunately, no way to avoid the damage a short sale does to your credit score. Generally, it drops about 100-150 points.

A short sale affects the credit score in each case, but the specific amount varies based on several factors. The negative effect can be better or worse, depending on your credit history, the scoring system being used, and what the lender’s criteria are.

FICO researched how short sales impact credit scores. In three hypothetical scenarios, there were three individuals with credit scores of 680, 720, and 780. The study found out that the person with the highest score was damaged the most – a 160 drop. At the same time, the person with the lowest score took only a 100-point hit.

Let’s see how the average credit score damage from a short sale compares to other situations:

  •  30 days late on payments: 40 to 110 points
  •  90 days late on payments: 70 to 135 points
  •  Short sale: 100 to 150 points
  • Bankruptcy: 130 to 240 points

It’s hard to tell what the effect would be in your specific case. But you can consult with a professional to assess whether you will be eligible for credit or loans and what your interest rates will potentially be.

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How Is a Short Sale Reported on Your Credit Report?

Does a short sale hurt your credit if a loan is technically paid? In most cases, yes. A loan that is paid by a short sale isn’t reported as “paid in full.” Instead, it can be reported as a charge-off, a settlement, a deed-in-lieu of foreclosure, or “settled for less than the full amount due.”

Also, if you had late payments preceding the short sale can be reported to the credit bureaus. This means once you’re 30 days behind, late payment can pop up on your credit reports and stay there for years.

How Long Does a Short Sale Stay on Your Credit Report?

A short sale is considered a serious derogatory event in your credit history, similar to a foreclosure. Both events can remain on your credit report for up to seven years. The countdown starts from the original delinquency date of the mortgage.

As for how long it has an effect on your credit score, the timeline is shorter. The FICO model used to calculate your credit scores places the most emphasis on the most recent 24 months. In a couple of years, you should see steady improvements.

What does short sale mean on a house loan? The waiting period before buying another home after a foreclosure or a short sale are as follows:

  • Foreclosure: It takes up to 72 months before a lender will offer any kind of interest rate that is reasonable.
  •  Short sale: It takes about 18 months to get a good interest rate. Federal Housing Administration (FHA) also adopted guidelines in 2010 that make it possible to qualify to immediately buy another home. For more information, check the terms for FHA loans.

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What Are the Tax Implications of a Short Sale?

If a short sale results in a deficiency, you may no longer be under an obligation to repay the lender. How does a short sale affect your taxes in this case? The lender may not come after you for payment, but you will still need to pay federal taxes on the forgiven amount. This is because The IRS sees it as income.

The logic behind this is that a borrow claims relief from obligations under mortgage agreements. Essentially, this means they received income. The fact that you will now owe the IRS is, of course, less appealing.

Below are several exceptions where the IRS doesn’t consider a canceled debt as income:

  • Debts are usually not treated as income if that happens as part of a bankruptcy proceeding.
  • Insolvent taxpayers also don’t need to report forgiven debt. For more detail, this is a financial deficiency when a person’s total liabilities exceed their total assets.
  • Cancellation of qualified farm indebtedness is another exception. If for the last three years, a person received income from some sort of farming activity, it’s not a taxable event.
  • The same goes for nonrecourse debt. It’s a type of loan that does not allow the lender to pursue anything other than the collateral.

How to Recover from a Short Sale

Whether you’re planning to buy another house or not, it’s important to start working on your credit right away. There are tons of benefits to having good credit: excellent credit card deals, better car insurance rates, locked in utility services, and even a landing a job.

Here are some methods to minimize the short sale effects on credit scores:

  • Pay your bills on time. Your payment history makes up 35% of your score. For lenders, past payment performance is also considered a good predictor of your credibility in the future. So, paying all your bills on time as agreed every month goes a long way.
  • Start an emergency fund. A lack of savings can still hurt your credit indirectly. If you don’t set aside money to cover immediate expenses, you may feel forced into a financing option that could hurt your credit more and cost you a lot of money.
  • Create a budget and stick to it. Budgets are useful financial tools that help prevent pitfalls along the way. Without this roadmap, it’s hard to be aware of where your money is going. Ultimately, this ignorance can hurt your credit in the long run.
  • Don’t close credit card accounts. Check your credit report to identify your oldest credit card accounts to keep them open. This will maintain the age of your accounts and your credit utilization ratio.
  • Apply for new credit. Opening a new credit card improves your overall credit limit. If it’s hard to get approval, start with a secured credit card or credit-builder loan. But remember not to apply for too much new credit; otherwise, it would lead to multiple inquiries.

The FICO study we mentioned above concluded that you can fully recover from a short sale in about seven years. In the meantime, you can still see gradual improvements if all your obligations are paid as agreed.

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Alternatives to a Short Sale

A short sale is an alternative to foreclosure. But there are also alternative solutions to short sales when you can’t afford mortgage payments. Before you decide on which course to take, we recommend looking at all viable options:

  • Refinance – Here, there is a possibility to revise the interest rate, payment schedule, and terms of a previous mortgage agreement. Creditors tend to accept new terms when the interest rate environment substantially changes.
  • Loan modification – This option is similar to refinancing, where you can make a change to the terms of an existing loan. If you absolutely can’t afford your mortgage payments, the lender may modify them so that you don’t fall behind.
  • Forbearance – This is a form of repayment relief involving temporary postponement of mortgage payments. If you expect to solve your financial troubles in less than a year, you can benefit from the forbearance period.  However, your lender may expect you to pay back everything in a lump sum later.
  • Deed in lieu – You may voluntarily transfer the deed to your home to the lender. It’s considered the last resort when the property owner has exhausted all other options.

Bottom Line

Can I buy a house after a short sale? It depends on what you do after. Compared to foreclosure, the waiting period after a short sale isn’t as long, and you may qualify for cash relocation assistance. Still, your credit rating is likely to take a hit. You need to take action as soon as possible to improve your financial situation.

We want to point out that once your house is out of the picture, your debts essentially become unsecured. In this case, a lender reserves the right to pursue a creditor. So, you need someone experienced in debt settlement to negotiate with your lenders.

This has been only a general overview, and if you want to know more about dealing with debt, contact our team at Debt Quest USA. We will explain the facts and help you to get on the right path to debt resolution.

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