For many people in a tough position, a short sale on a home may seem like the best option to avoid foreclosure. But before making that decision, it's important to understand: Do short sales affect your credit?
In this article, we'll explore what a short sale is, compare it to foreclosure, and outline how both options can impact your credit score. We also asked a finance expert and a real estate investor to offer actionable steps to rebuild your credit after a short sale or foreclosure.
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What is a short sale?
A short sale occurs when you sell your home for less than the amount still owed on your mortgage. This typically happens when the value of the home has decreased, leaving the homeowner “underwater” on their mortgage. In this situation, the lender agrees to accept the sale price as full payment, even though it’s less than the outstanding loan balance.
Does a short sale affect credit? Yes. Although short sales are often seen as a way to avoid the harsher consequences of foreclosure, they still come with credit implications.
“In contrast, a foreclosure happens when the homeowner defaults on their mortgage, leading the lender to seize the property to recoup the unpaid loan amount,” says Brandi Simon, real estate investor and owner of TX Home Buying Pros. “The property is then sold at auction or through other means to recover the lender's losses.”
Many people opt for a short sale when they are unable to pay their monthly mortgage payments, but want to avoid foreclosure. But before deciding if that’s the right move for you, it’s key to understand how a short sale affects your credit.
Short sale vs foreclosure credit impact: Which is more favorable?
What are the disadvantages of a short sale? And of a foreclosure? Balance both the financial and credit impacts when deciding between them.
Understanding the impact of a short sale
Does a short sale affect your credit?
Yes, a short sale can significantly lower your credit score, but the exact amount varies based on your starting score and overall credit history. According to data from FICO, on average, a short sale can cause a credit score drop of 85 to 160 points. The higher your score before the short sale, the larger the drop is likely to be.
If your home’s short sale is reported to credit bureaus as “settled for less than the full balance,” it may have a slightly less negative impact than a foreclosure, but it still signals to lenders that you were unable to fulfill your original loan agreement.
How long does a short sale affect my credit?
It will stay on your credit report for seven years from the date of the first missed payment. During this time, these negative marks will affect your ability to obtain credit, secure favorable interest rates, and even rent an apartment.
“However, the impact of a short sale may lessen over time, especially if the homeowner is diligent in rebuilding their credit,” Simon says. After the first two years, the negative effect on your credit score may start to diminish, provided you take steps to rebuild your credit. (We will dive into these steps next).
Can I get a mortgage with a short sale on my credit report?
Yes, you can, though it involves some considerations and requirements. The waiting period before you can apply for a new mortgage varies depending on the type of loan. For instance, FHA loans usually require a 3-year wait, VA loans typically require two years, conventional loans often necessitate a 4-year wait, and USDA loans generally require three years.
While a short sale might seem less damaging to your credit score, it still requires approval from your lender and can take months to complete.
Understanding the impact of a foreclosure
How badly does a foreclosure affect your credit?
Foreclosure can have an even more severe impact on your credit score than a short sale, typically resulting in a drop of at least 100. Here too, the exact impact depends on your initial credit score.
A foreclosure also stays on your credit report for seven years, making it harder to secure new credit during this time.
Alternatives to short sales and foreclosures
Before opting for a short sale or foreclosure, consider that there are other options that may have less impact on your credit score:
- Loan modification: If you’re struggling to make mortgage payments, contact your lender to discuss a loan modification. This involves changing the terms of your loan, such as extending the repayment period or reducing the interest rate, to make your payments more affordable.
- Refinancing your mortgage: This can lower your interest rate and monthly payments, making it easier to stay current on your loan. However, refinancing requires good credit and sufficient equity in your home, which may not be an option for everyone.
- Renting out your property: If you’re unable to sell your home or keep up with mortgage payments, consider renting out your property. This can generate income to cover the mortgage and prevent a short sale or foreclosure.
- Government assistance: Several government programs are available to help homeowners avoid foreclosure, such as the Home Affordable Modification Program (HAMP). Research these kinds of programs to see if you qualify for assistance.
7 steps for rebuilding credit after a short sale or foreclosure
“Choosing between a short sale and foreclosure is never easy, but understanding the long-term implications on credit and taking proactive steps to rebuild can make a significant difference,” Simon says.
Rebuilding credit after either event involves several stages, says Jonathan Gerber, CPA, MBT, and President of RVW Wealth, a money management firm. We’ve covered the steps below, but Gerber also suggests “working with a credit counselor to develop a plan tailored to your situation.”
2. Factcheck: Review your credit report
Start by obtaining a free copy of your credit report from each of the three major credit bureaus: Equifax, Experian, and TransUnion. Review the reports for any errors related to the short sale or foreclosure and dispute them if necessary.
3. Create a budget to rebuild your credit
Develop a budget to manage your finances and avoid falling behind on payments in the future. Prioritize essential expenses like housing, utilities, and food, and allocate a portion of your income toward rebuilding your credit.
By creating and sticking to a well-organized budget, you’ll not only manage your finances more effectively but also set a strong foundation for achieving long-term financial stability.
4. Pay your bills on time
“Establish a positive credit history by paying bills on time and using credit responsibly,” Gerber says. Payment history accounts for 35% of your credit score, making it the most important factor in credit recovery. Make sure all bills, including utilities, credit cards, and loans, are paid on time each month.
Lenders use your payment history to assess the risk of lending you money. A strong history of timely payments indicates lower risk, while missed or late payments suggest higher risk.
Setting up automatic payments or reminders can help ensure you never miss a due date. Focus on paying essential bills first, such as rent or mortgage, utilities, and minimum credit card payments. Ensuring these are paid on time helps protect your credit score.
5. Reduce your credit card balances
High credit card balances can negatively impact your credit utilization ratio. The credit utilization ratio is the percentage of your available credit that you're currently using. It's calculated by dividing your total credit card balances by your total credit limits and then multiplying by 100 to get a percentage.
For example, if you have a total credit limit of $10,000 across all your credit cards and your combined balances amount to $3,000, your credit utilization ratio would be 30% ($3,000 ÷ $10,000 × 100 = 30%).
This ratio is an important factor in your credit score, making up about 30% of the overall score calculation. A lower credit utilization ratio is generally better for your credit score, with experts recommending that you keep it below 30%.
Keeping your balances low relative to your credit limits shows lenders that you’re managing your credit responsibly.
6. Get a secured credit card
If you are having trouble obtaining a standard credit card, a secured credit card is a useful tool for rebuilding credit. It’s a type of credit card that requires a cash deposit as collateral to open the account. This deposit usually acts as your credit limit, meaning if you deposit $500, your credit limit will be $500. The deposit reduces the risk for the lender, making it easier for individuals with poor or no credit history to obtain a credit card.
Secured credit cards work like regular credit cards. You can make purchases, and you’ll need to pay off the balance each month. By using the card responsibly—making on-time payments and keeping your balance low—you can build or rebuild your credit.
7. Avoid applying for new credit too soon
While having a credit card (whether standard or secured) can be a helpful tool in rebuilding your credit, be judicious when it comes to applying for new credit. Each time you apply for credit, it triggers a hard inquiry on your report, which can temporarily lower your score.
Multiple recent applications can reduce your chances of approval for new credit. Lenders may view numerous applications as a sign of financial instability, which could result in denials or less favorable terms.
8. Stay patient and consistent
Rebuilding your credit takes time, but consistency is key. By following these steps, you’ll gradually see improvements in your credit score, and over time, the impact of a short sale or foreclosure will diminish.
“Patience and careful planning are essential as you work towards rebuilding your credit and achieving long-term financial stability,” Gerber says.