Foreclosure vs. Short Sale: What’s Worse for Your Credit?

More and more underwater homeowners are asking how their credit scores will fare after a short sale or foreclosure — and how the two outcomes compare. It’s a good question, since the homeowner will have to live with the consequences of this decision for at least seven years, the length of time “derogatory” information remains on a credit report.

Whereas you can expect a loan in foreclosure to appear on your credit report as a “foreclosure,” there is no such single, universally accepted description for short sale on credit reports, such as, well, “short sale.” Instead, a loan paid via short sale tends to be labeled as either “charge off,” “deed-in-lieu of foreclosure,” “settled for less than the full amount due” or “foreclosure” — all having about the same negative impact on your score as a foreclosure.

Does this mean then that a foreclosed mortgage loan appearing on your credit report will always have about the same impact to your score as a short sale?  As with many credit scoring issues, the answer is both yes and no, depending on other information being reported about the loan — in this case, the balance and the past due amount. Generally, the higher these dollar amounts, the lower the score.

To dig a little deeper into the specifics, when a foreclosure is reported by a lender to the CRA (credit reporting agency), the balance appearing on the credit report for that item consists of the entire unpaid loan amount as of the date it went to foreclosure.  For a short sale, the reported balance should be made up of the outstanding loan amount as of the date of the short sale, less the sale amount received from the buyer and agreed to by the lender.  If the difference between the reported balances under each of these two scenarios is substantial — and it should be — the negative impact to the score will be less for a short sale than a foreclosure regardless of whether the mortgage is reported as a foreclosure, charge off, or other derogatory notation.

Past due amounts reported for a mortgage loan will impact the score similarly, as a higher past due amount leads to a lower score.  Typically, when a loan in foreclosure appears on a credit report, the entire outstanding balance also appears as the past due amount. For a short sale, there should not be any past due amount reported — another plus on the short sale side of the equation.

But before future short sale sellers get too excited about this seemingly good news, they should also understand that any scoring benefits resulting from a short sale/foreclosure comparison are not likely to be either significant or long lasting. Such advantages tend to dissipate within a short period of time, as other, more recently reported information begins to have more of an impact on the score.

Nor is it a good idea to base a short sale vs. foreclosure decision strictly on the anticipated impact to a credit score, when other factors, such as the ability to qualify for a mortgage in the future, are likely to affect your finances and general well-being long after your credit score has begun to recover. For example, despite the fact that a short sale resulting in a “foreclosure” status should not impact a score quite as negatively as an actual foreclosure, a consumer with a foreclosure on her credit report — whether from a short sale or foreclosure — could be prevented from qualifying for a new mortgage for up to seven years by Fannie Mae and other sources of mortgage lending.