How a Short Sale Will Affect Your Future

In this article:

• What Is a Short Sale?
• How Does the Short Sale Process Work?
• How Does a Short Sale Impact your Credit?
• How Long Until You Can Buy Again?
• Other Considerations

What is a Short Sale?

A short sale occurs when the bank allows a homeowner to sell a home for less than what is currently owed to the bank. For example, if you owe the bank $200,000 but sell the home for $180,000 (and can't pay the $20,000 still owed), the sale would be considered a short sale, as the mortgage lender would be receiving less money than it is owed. You can only do a short sale if the bank approves the transaction.

How Does the Short Sale Process Work?

Typically, you'll need to contact the bank once you realize that you cannot make the mortgage payments. You will need to prove to the bank that you cannot make payments, and must prepare documents for the bank (these vary from bank to bank) showing an inability to pay, including a hardship letter stating what is happening that makes you unable to pay, two years of tax returns and W-2s and other financial documents, as well as a list of home sale prices in the area to show the likely market value for the home.

A lender will only accept a short sale if you can show both an inability to repay the loan and that the proceeds from a sale of the home could not fully repay the amount the owed. Once the bank approves a short sale -- and you and the bank sign papers to this effect -- the home goes on the market. The home could sell quickly, or it could take months, so be prepared to continuously show the property. As soon as escrow closes, you will need to move out of the home.

How Does a Short Sale Impact Your Credit?

A short sale will ding your credit, and in some circumstances, that ding may be nearly as severe as it would have been if you'd foreclosed on the home (both foreclosures and short sales are treated like a default on a loan). Experts estimate that a short sale could lower your credit score by as much as 200 points, so a score that was close to 800, which is excellent, could fall to 600, which is merely OK -- meaning that you'll likely be charged higher interest rates on the credit cards and loans that you get going forward.

If the short sale was an isolated non-payment incident, it will have a lesser impact on your score than if it was one of many non-payments. (Note that some lenders will allow a short sale even if a borrower hasn't yet missed any payments -- a scenario that would likely have the least impact on your credit score.)

How Long Will Until You Can Buy Again?

The time you'll have to wait before buying another home after a short sale depends on the type of loan you want and the down payment you'll put down. For example, Fannie Mae makes you wait four years after a short sale if you put 10 percent down on your new loan; two years if you put 20 percent down; and two years if you put down 10 percent but also have extenuating circumstances such as an illness. In most cases, you will need to wait at least a couple of years before buying, though in rare cases you can buy immediately after a short sale.

Other Considerations

In some cases, a short sale may have some unpleasant tax consequences. This often happens to homeowners who tapped their home equity during the market upswing and then used that money for purchases -- such as vacations, cars or college tuition for the kids – that were unrelated to upgrading their homes.

For example, say you owe $200,000 on your original mortgage and $50,000 on a home equity loan, which you used for purchases unrelated to improving your home. You arrange a short sale on your house and get $190,000. You repay the lender for the original mortgage $180,000 and the home equity lender $10,000. The $20,000 (the difference between the $200,000 you owe and the $180,000 you are repaying with the sale of your home) that the original mortgage lender will forgive is not considered taxable income, but the $40,000 that you didn't repay in home equity would be considered taxable income because it wasn't used to improve your home.