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Are large numbers of homeowners who have negotiated short sales with lenders at risk because of a startling omission in the American credit system? Do their credit reports and scores indicate that they were foreclosed upon, rather than having negotiated a mutually agreeable resolution with their lender?
The answers appear to be yes, and in May, two federal agencies – the Federal Trade Commission and the Consumer Financial Protection Bureau – were asked to investigate why. The reality is this: The credit reporting system now in place does not have a separate code that distinguishes a short sale from a foreclosure. Yet there are crucial differences between the two:
• In a short sale, the bank approves the sale of the house to a new buyer at a mutually acceptable price. Any unpaid remaining loan balance not covered by the sale proceeds may then be either partially or fully forgiven. The bank is an active participant throughout the process, negotiating for a higher price and higher repayment of principal from the original borrower.
• In a foreclosure, the bank is essentially left holding the bag. The owners walk away at some point or live in the property rent-free until they’re evicted. Frequently there is damage to the house left by the departing owners, sometimes extensive. There is little or no cooperation between them and the bank.
Both transactions are serious, negative credit events for the borrower. After all, the mortgage wasn’t fully repaid. But the financial losses generated by a foreclosure typically are more severe for the lender than a short sale. Not only are there extended periods of nonpayment by the borrower but there are also substantial property management expenses, renovation costs, local property taxes and insurance while the house is being readied for resale. In some parts of the country, the average time to complete a foreclosure has exceeded two years.
The nation’s major sources of mortgage financing – Fannie Mae, Freddie Mac and the Federal Housing Administration – all recognize the differences between short sales and foreclosures in their underwriting policies regarding new mortgages. Fannie Mae generally won’t approve a new mortgage application by borrowers with a foreclosure on their credit report for up to seven years, but will consider lending to people who were involved in short sales – and who otherwise qualify in terms of recent credit behavior and available down payment – in as little as two years.