The Consequences for Homeowners with a Foreclosure Vs. a Short Sale

If you must move out of your home because you can no longer afford the payments, you may face two options. Foreclosure is typically the last resort after exhausting the possibilities of loan modification, forbearance, deferment and refinance. Lenders often prefer to sell the home at a loss through a short sale, also known as a pre-foreclosure sale. Your lender must approve all sale terms and the consequences are often more favorable than foreclosures.

In a short sale, your lender voluntarily agrees to let you sell your home for an amount that falls short of paying off your mortgage obligation. The process involves extensive review of your finances and economic hardship, which typically takes several months. A lender may agree to a short sale to avoid the expense and hassle of foreclosure and property maintenance. You face the same consequences from a foreclosure and short sale, although the short sale is generally considered a better alternative and treated more favorably under certain circumstances.

Because both a foreclosure and short sale involve delinquent mortgage payments, their affect on credit is equally severe. Lenders report both events as "accounts not paid as agreed," My FICO says. As such, both diminish scores by 85 points to 160 points, with better scores having the greatest drop, according to CNN Money.

The tax consequences of a foreclosure and short sale depend on whether the home is located in a recourse or non-recourse state. In a recourse state, the lender may pursue your for the deficiency or shortfall from the foreclosure auction or short sale. A foreclosure may also trigger a cancellation of debt for income-reporting purposes. As such, you must report the lender's loss, known as a deficiency, as income. In a non-recourse state, the lender extinguishes the debt in exchange for taking ownership of the home in foreclosure. A short sale in a non-recourse state doesn't trigger a cancellation of debt burden because the loan is considered fully satisfied, according to Smart Money.

Your future mortgage lender is likely to forgive a short sale sooner than a foreclosure. The Federal Housing Administration, which backs loans made by approved lenders, has flexible qualifying guidelines. The FHA requires you to wait at least three years after a short sale or foreclosure and reestablish good credit before buying another home. Non government-backed loans, known as conventional financing, require buyers to wait four to seven years, depending on their down payment, after a foreclosure and as few as two years after a short sale.