Can I Buy a House After Going Through a Short Sale?

By Brandon Cornett
© 2011 All rights reserved

Reader question: "We are in the middle of a short sale with our home. Like many homeowners, we owe more on the house than it's worth. We have to sell because we are moving for a job transfer. The lender agreed to let us go with the short sale process. It would be nice to buy another house down the road, after we get settled in our new city. Will this be possible, do you think? Can we buy a house after a short sale on the last one?"

Let me start with the short answer. Yes, buying another home after a short sale is certainly possible. The "when" question is harder to answer. Among other things, it will depend on how your lender reports the loan payoff to the credit-reporting bureaus.

If they report it as anything less than "paid in full," it will hurt your credit score. That, in turn, could hurt your chances of qualifying for another mortgage loan down the road. You might want to ask your lender how they are going to report it.

What is a Short Sale?

We will talk more about buying a house after a short sale in just a moment. But first, I want to explain what this term means in the first place. Some of our readers may not be familiar with the subject.

Definition: A real estate short sale is when you sell your home for less than you owe on your mortgage. In more legal terms, it's when the proceeds earned from the sale fall short of the principal balance owed on the mortgage loan.

This strategy is often used after a significant loss in property value. That's why short sales are so common today -- many people have lost value in their homes since the housing crash.

An Example Scenario

Let's say I purchased a home in 2003 for $380,000. I put $30K down and got a loan for the remaining $350,000. Now it's 2011, seven years later. I've only reduced my loan principal by about $37,000 during the first seven years. (Remember, most of your mortgage payment goes toward interest in the early years of the payback period, due to amortization.) So my current loan balance is $313,000.

In 2011, I try to sell my home. But during this process, I find out that my property value has dropped considerably. The buyer's mortgage lender sends an appraiser out to my home, and he says it's only worth $270,000 in the current real estate market.

I owe $313K, but the appraiser says it's only worth $270K. I am underwater in the loan.

Under normal circumstances, I would use the proceeds from the sale of my home to pay off my existing mortgage balance. But that's not possible in this scenario. The proceeds from the sale will fall short of the amount I owe on the home loan. If I sell it for $270,000 (the current appraised value), I would still be $43,000 short on paying off my mortgage balance. So the only way I can sell the house is by getting the lien holder's blessing. The lien holder would be my mortgage lender, or whomever they sold the loan to.

This is where the short sale comes into the picture. It is called this because you are selling the home short, for less than what you owe. And you need your lender's permission to do it.

In some cases, the lender will allow this strategy. It's all business to them. If it would cost the lender more money to foreclose on the house, then they might go ahead with the short sale. But if you're current on your payments, they might reject the notion of a short sale. They'll make more money in the long run if you just keep making your mortgage payments.

But I digress. You said you're in the middle of the process right now. So I can safely assume you've already received clearance from your lender to proceed with the sale. So let's get back to the topic at hand:

Can I buy a house after a short sale?

As I said earlier, it's entirely possible to buy another home after going through a short sale process on your previous home. The real question is, how soon will you be able to do it? This will largely depend on what happens to your credit score after the sale. So let's talk about that next...

What Happens After the Short Sale

These days, FICO credit scores are one of the most important factors for mortgage approval. If you want to get approved for another loan someday, you'll need to have a decent credit score. Going through a short sale can damage your credit score. How much damage it does (or whether it does any damage at all) will depend on how your lender reports it to the credit-reporting bureaus. Now we are getting to the heart of the matter.

Generally speaking, a short sale does less damage to a person's credit score than a foreclosure. But they can both lower your score. In truth, there is no credit-reporting code for "short sale." So it might not show up on your report, at least not in those exact words. The lender may report it as a debt settlement or a charge-off.

Both of these labels are accurate, when you think about it:

• Through a short sale, the lender is basically agreeing to accept less than the full amount you owe. This is the textbook definition of a debt settlement.
• They will probably "absorb" the loss as well (the difference between what you owe and what they receive through the sale). This is the textbook definition of a charge-off.

So the lender could use either one of these categories when reporting the short sale to the credit-reporting companies. According to Fair Isaac Corporation (the company that created the FICO scoring model), short sales are usually treated as "not paid as agreed" accounts. And that can have a negative impact on your FICO credit score.

Related article: How does a short sale affect my FICO score?

Now you can see why it affects your ability to buy a house after a short sale. If the lender reports it as an account that was not "paid as agreed," it can lower your FICO score. This in turn will hurt your chances of getting another mortgage loan down the road.

Of course, with time and "good behavior," your score will eventually rebound. It's just a question of when. And that's not something I can answer. It will depend on (A) the amount of damage that was done, (B) the proactive steps you take to improve your credit, and (C) the other types of derogatory entries you might have on your report.

Other Criteria for Buying a House

We talked about your credit score in the previous section. But that's one of several criteria mortgage lenders will use when considering you for a loan. If you want to improve your chances of buying a house after the short sale, you need to understand all of the qualification criteria.

Debt-to-income ratios [definition] are also a big deal these days. This is a comparison between the amount of money you earn, and the amount you spend each month to cover your various debts. In this context, I'm talking about the debts that show up on your credit reports (student loans, car loans, retail accounts, credit cards, etc.). The more income you spend to cover these obligations, the lower your chances of getting approved for a loan. It might be easier to buy another home after your short sale if you pay down some of your other debts first. It certainly can't hurt. 

Your down payment also plays a role in whether or not you get approved. With all other things being equal, a larger down payment will improve your chances of getting a mortgage loan. It might help you secure a lower interest rate, as well. So you have two good reasons to save your money.

Disclaimer: This article answers the question: Can I buy a house after a short sale? This information is provided for educational purposes only. Every home-buying scenario is different, because every borrower is different. Thus, you should not take this article as the final word on the subject. Only a mortgage lender can tell you whether or not you meet their guidelines for approval.