Short Sales and the FICO Score

By Josh Cantwell:

It’s not hard to find chatter on the blogs concerning how a short sale or a foreclosure affects a FICO score. Frankly, even if it were the same, the differences between a deficiency judgment and a negotiated note are considerable: There’s no gray area here.

As a homebuyer you need to be sure to explain the benefits to the homeowner if you are able to buy their house, as well as the negatives if the house should be sold at auction.

In the past, investors have claimed that a foreclosure would greatly harm one’s credit while a short sale would allow the homeowner to move forward to enjoy a faster recovery. What has been implied in this statement is that the overall damage to one’s credit in terms of points would be greater in a foreclosure than a short sale, when in fact there may be little credit preservation advantage of a short sale over a foreclosure.

As a result, many homeowners have been advised by real estate professionals who saw little benefit in a short sale to allow the house to go into foreclosure.

This was wrong.

Make no mistake, there are definite advantages to a short sale beyond allowing the homeowner to move on emotionally from the foreclosure, but it has little to do with how many points a short sale will drop a FICO versus a foreclosure.

Naturally, the best outcome for the homeowner is to sell the house for what they owe on the balance of their mortgage, if not more. For real estate agents, this is what they hope to do for each of their clients. Unfortunately, in most communities, houses are over valued and markets will no longer support asking prices. Likewise, as of this writing, only three communities in the US currently having rising appreciation, strong sales and few if any foreclosures. Only three! If the homeowner is unable to structure a workout or a forbearance agreement with the foreclosing lender, then a short sale is the next best option.

The benefits are twofold.

First, be aware that Fannie Mae recently established a 2-year elapsed time period for reestablishing credit for homeowners who sell their homes through a short sale. Two years may seem like a long time to wait before being able to get a new loan, but compare this to what happens if the homeowner goes through the foreclosure process. According to the Fannie Mae guidelines, effective May 31, 2008, a homeowner who has filed a foreclosure will be “ineligible” for a loan for five years.

Did you see that? FIVE YEARS!

Two years or five years…? That’s something definitely worth considering.

The other benefit involves something called a deficiency judgment.
When a house is sold at auction, the chances of the foreclosing lender filing a deficiency judgment increases dramatically. As investors, we’re in the business of buying properties, but often the negotiation process used to achieve a short sale with the bank gives the homeowner their only shot at avoiding a deficiency judgment.

A quick review… As many of you know, a deficiency judgment is obtained when a property is foreclosed and sold (usually at the courthouse by the clerk of the court) to the highest bidder. In most states a deficiency judgment can be obtained for the difference between the high bid and the higher foreclosure judgment amount. Usually the court determines which value is higher, the high bid or the appraised value of the property on the date of the public sale. The higher of the two is taken to determine the difference from the judgment amount, and this difference is the deficiency judgment (what was owed subtracted by the final sale price).

Deficiency judgments are just that: judgments. They are an albatross around the neck of the debtor and can only be removed by paying it off or by bankruptcy. Furthermore, deficiency judgments usually earn interest until paid. In Florida right now that rate is 11% a year ––better than the bank by far!

If a homeowner is saddled with a deficiency judgment, guess what? They won’t be able to buy anything using credit. New house? Forget it. New car? Forget it.

While in the past we have seen few deficiency judgments filed against foreclosing homeowners, today that landscape has changed.
We once were under the impression that banks seldom enforce deficiency judgments, which is true ––they sell the judgments for 5 to 10 cents on the dollar. Here’s the deal that the bank has to consider . . .for a $100,000 deficiency judgment they invest $500 in attorney fees and get $10,000 in return just for pushing paper. What do you think they are going to do?

For those unsecured promissory notes you negotiate on some of your deals, the same is true. The banks do the same thing –– getting 5 cents on the dollar.

Another point of consider, if the house goes into foreclosure and is taken back by the bank to be listed as an REO, the meter keeps running on the costs incurred by the bank until the REO dept. sells the house. This can make the deficiency huge.

Again, as investors we offer homeowners a way out. Whatever effect a short sale has versus a foreclosure on one’s FICO score pales in comparison to the long term harm of a deficiency judgment and the inability to be approved for a loan for years to come.

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