How A Short Sale Affects Your Credit Score

If you’d asked most U.S. homeowners in 2005 to define a "short sale," there’s a good chance they wouldn’t have an answer. Few homeowners had dealt with a short sale – the process of selling a home for less than what they owe on the mortgage – before the housing market crash of 2008.

But just three years later, more than one-third (38.6%) of single-family homes in the U.S. were considered distressed sales, including bank-owned properties, third-party foreclosure auction sales, and short sales. A decade later, distressed sales account for 14% of all single-family home sales in the U.S.

If you are having trouble making your mortgage payment, the fact that short sales are less common than they once were is likely cold comfort. Unfortunately, a short sale will negatively impact your credit score, but the question is by how much.

The short sale's effect depends on a number of factors, and you may be able to get into a new home faster than you think. Let’s look at what a short sale means for you and your credit.

What is a short sale?

As mentioned above, a short sale is a process in which a homeowner sells their home for less than what they owe on the mortgage. Once the sale is finalized, the seller ends up “short” of the amount they need to pay back the total loan.

The lender agrees to accept the lower sales price to avoid having the home go into foreclosure, which is a costly and time-consuming process. Lenders usually require the seller to prove financial hardship before approving a short sale.

How does a short sale affect your credit score?

You may be surprised to learn that the term "short sale" will not appear anywhere on your credit report. According to Experian, your credit report will indicate a "negotiated settlement" of your mortgage for less than you owe.

The immediate credit damage of that negotiated settlement will depend on a number of factors including your prior credit history and whether you were behind on your mortgage payments before the sale.

FICO studied how mortgage delinquencies such as late payments, short sales, and foreclosures impact credit scores. They used three hypothetical consumers with credit scores of 680, 720, and 780. The 2011 study found that the consumer with the highest credit score saw the biggest hit to their FICO score, with a drop of up to 160 points. Meanwhile, the credit score of the consumer with a lower starting score dropped by only about 100 points.

But the mortgage itself isn’t the only account that will impact your credit score after a short sale. After the settlement is reported to the credit bureaus, your credit card companies may lower your credit limits.

This happens because the credit card companies see the negotiated settlement as a sign that you’re having financial troubles and want to limit their exposure in case you stop paying your credit card bills. Unfortunately, the reduction in credit limit also increases your credit utilization percentage, which is a factor your credit score (lower is better).

Whatever the immediate effect of the negotiated settlement, a short sale will affect your credit report for seven years. However, the impact of the short sale will be less with each year that goes by because recent credit actions have a bigger impact on your credit score than events from the past.

In fact, if you work on rebuilding your credit, you may be eligible for a new mortgage in as little as two years, according to Fannie Mae.

How can you rebuild your credit after a short sale?

Whether or not you’re interested in buying a new home right away, you should work to rebuild your credit and credit score. Not only will this improve your chances of getting approved for a new loan when the time is right, but it will also help ensure that you are financially capable of handling loan payments when the time comes.

Here’s how to get started rebuilding your credit after a short sale.

• Start an emergency fund. With your credit limits lowered, you won’t be able to tap credit cards as extensively in the event of an emergency. Start setting money aside so unforeseen expenses won’t leave you unable to pay your bills. (Emergency savings accounts are also often called rainy day funds.)
• Create a budget. To rebuild your credit, you will need to pay down your remaining credit card debt. A budget can help ensure you know how much money you have coming in each month versus how much goes out to cover minimum debt payments and living expenses.
• Pay your bills on time. Payment history accounts for 35% of a FICO credit score calculation, so it’s important to pay your bills on time. Set up payment reminders or enroll in automatic payments to ensure you’re not delinquent again.
• Don’t close credit card accounts. Closing a credit card negatively impacts your credit score by reducing the age of your accounts and lowering your credit utilization ratio.
• Apply for new credit. If you don’t have many open accounts after a short sale, you may want to try rebuilding your credit by opening a new credit account. If you have a hard time getting approved for a major credit card, start with a secured credit card or credit builder loan.

The FICO study mentioned above also looked at how long it takes for a person’s FICO score to recover after a short sale. According to their research, “while a score may begin to improve sooner, it could take up to seven to ten years to fully recover, assuming all other obligations are paid as agreed.”

Alternatives to a short sale

A short sale is a viable alternative to foreclosure, but it’s not the only solution if you can’t afford your mortgage. You should investigate all available options before deciding which course of action you will take. Here are some alternatives.

• Refinance. If you have equity in your home, you may be able to refinance your mortgage with a lower interest rate or longer term to reduce your monthly payments.
• Loan modification. If you’ve fallen behind on your monthly mortgage payments, your lender may be willing to adjust the terms of your existing loan and modify payments so you can afford to make them.
• Forbearance. If your financial troubles are temporary and you haven’t missed any mortgage payments, your lender may agree to a temporary reduction or suspension of your loan payments. Forbearance is usually granted for three to 12 months. At the end of the forbearance period, the lender will expect all of your missed payments, either in a lump sum or through a repayment plan.
• Deed in lieu. Rather than go through a costly and time-consuming foreclosure process, you may voluntarily transfer the deed to your home to the lender.

The right solution for you depends on a number of factors, including your overall financial situation and your lender’s willingness to negotiate. Before you take action, it’s a good idea to get professional advice from your accountant, lawyer, or a HUD-approved housing counselor.

A short sale may be better than foreclosure

For people having trouble making their mortgage payments, a short sale offers many benefits over a foreclosure. The waiting period for getting a new mortgage after a short sale is typically shorter than the waiting period after a foreclosure (seven years, according to Fannie Mae), and you may qualify for cash relocation assistance.

Your credit rating will take a hit after a short sale, but you can take action right away to start rebuilding your credit score and improving your financial situation.

About the author

Janet Berry-Johnson is a Certified Public Accountant and personal finance writer. Her work has appeared in numerous publications, including Credit Karma and Forbes.