How can a short sale impact your credit score?

While the United States housing market improved in 2013, at the end of the year 19% of homeowners with a mortgage owed more on their mortgage than the value of their home.

For homeowners with no plans to move and who can comfortably afford their mortgage payments, being underwater certainly can be frustrating. However, those homeowners have the option of waiting until the combination of rising home values and their continued loan repayment brings them back “above water.”

Homeowners who are struggling financially and can’t make their payments or who must relocate for employment face a bigger issue if they’re underwater on their home loan because they cannot sell their home for a profit and move. Some of these homeowners can qualify for a government refinance program or a loan modification from their lender, but others face a choice between letting the mortgage lender take their home in a foreclosure and negotiating a short sale.

A short sale simply refers to the situation when a borrower asks the lender to accept a loan repayment for less than the full amount. The amount offered depends on the sales price negotiated between the lender, the seller and a buyer. You’ll have to provide proof of a hardship such as a change in your finances that makes the payment unaffordable or mandatory job relocation.

If you’re able to get your lender to agree to a short sale, you may or may not be responsible in the future for the gap between the balance you owe and the amount actually repaid. This depends on the state where you live and your lender’s decision about seeking recourse.

Short Sales and Your Credit

Many homeowners prefer a short sale to a foreclosure because they believe there’s less of a stigma attached to a short sale and that it won’t necessarily damage their credit as much. However, both a foreclosure and a short sale can lower your credit score and will stay on your credit report for seven years. Over time, though, you can improve your credit score through credit rebuilding techniques such as paying all your bills on time, reducing your debt, and, if necessary getting a secured credit card and making regular payments.

The impact of a short sale on your credit depends on several factors, including the way your lender reports the short sale to the credit bureaus. Most lenders will use the term “settled” for a short sale, which indicates that less than the full debt was repaid. If you can negotiate with your lender to use the word “paid” your credit won’t be as badly damaged, but lenders rarely agree to that.

Your credit score could drop by anywhere from 85 to 200 points depending on whether you have been paying your mortgage on time and your previous credit score. If, for example, you had good credit of 700 or above, your score might drop even more than someone who already had a low credit score of 620 or so because of a short sale is an indication of potential future defaults on other credit, especially if the borrower with low score had been making on-time mortgage payments. If you had months of non-payment, partial payments or late payments on your mortgage, your credit score will also be lower because of the combination of the short sale and a bad mortgage history.

In spite of the impact on your credit, a short sale may be the best option if you can’t stay in your home because you can move on from your current situation and begin to rebuild your credit for the future.