Short sale vs. foreclosure: What’s the difference?

When a homeowner faces financial difficulty, there are two scenarios that often come up: foreclosure and a short sale. A short sale is when the owner voluntarily sells their house for less than the amount they owe on their mortgage. This is done with the lender’s approval.

A foreclosure, on the other hand, happens when a lender seizes the owner’s home after too many missed mortgage payments, then sells the bank-owned property to recover their losses.

If you’re a buyer interested in one of these distressed property types, you might see them as a great deal for below market value. But knowing the difference between a foreclosure and a short sale is critical. Each comes with a unique set of risks, benefits, and paperwork. Why is there always paperwork?

Suffice it to say, these real estate transactions are not typical, so let’s look at what you can expect from each, including the good, the bad, and the sometimes ugly.

The difference between short sales and foreclosures

One thing that both foreclosures and short sales have in common is that they usually occur when homeowners can no longer afford their mortgage payments. They differ in significant ways, however.

A short sale is voluntary. The homeowner works with their lender to sell the home for less than is left on their mortgage – short. Foreclosure is involuntary. The lender has taken legal action against the homeowner to repossess the house and sell it to recoup their losses.

Homeowners can find themselves in either one of these situations due to losing their job, devastating medical expenses, unaffordable loan terms, or a host of other reasons. Regardless, understanding the differences between short sales and foreclosures is important for buyers so they can navigate the process smoothly.

Short sales

A short sale happens when, with the approval of their lender, a homeowner sells their property for less than their outstanding mortgage balance. Homeowners pursue this option when they owe more than the home is worth and can’t continue to make mortgage payments.

Homeowners often choose this method of getting out of their mortgage obligation rather than others, such as a deed in lieu of foreclosure – where the homeowner hands the deed back to the lender – because it’s not as harmful to their credit. For the savvy buyer, a short sale might offer an opportunity to purchase a property in relatively good condition at a good price.

Foreclosures

A foreclosure occurs when a lender repossesses a property because the homeowner has stopped making their mortgage payments. Unlike a short sale, in which the homeowner and lender work together, foreclosure is a legal action that the lender takes against the homeowner.

Properties that have been foreclosed on are often sold at auction and sell for below market value. However, they may also come with more risk, including needing significant repairs.

The foreclosure process

The foreclosure process is a slow one. It begins after the property owner misses months of mortgage payments. The lender then issues notices and, finally, takes legal action to repossess the property. Once the homeowner is vacated and the bank has legal possession of the property, they either list it for sale or auction it off.

On the road to foreclosure there are often offramps that the owner can take to avoid foreclosure and the devastation to their credit it can cause. Here are a few common ones:

• Deed in lieu of foreclosure: This is when a homeowner voluntarily forfeits the property’s deed back to the lender to avoid foreclosure proceedings.
• Forbearance: Here, the lender grants a temporary reduction or pause in the homeowner’s mortgage payments to give them time to pull their finances back in order.
• Deferment: This is a process that allows borrowers to move missed payments to the end of the loan term. In this way, they “reset” and continue their mortgage payments.
• Preforeclosure: This is a stage before the foreclosure is finalized when the homeowner can still sell the home or negotiate with the lender to avoid foreclosure.

Because of the complex nature of foreclosures, if you’re a buyer considering purchasing a foreclosed property, it’s a good idea to work with a real estate agent with experience in these negotiations.

Pros and cons of foreclosure

Buying a house that has been foreclosed on has some unique advantages, but it also comes with potential risks and hurdles.

Pros of a foreclosure

Navigated properly, buying a foreclosure property can be a great financial move. Here are three potential advantages.

• Lower purchase price: This, of course, is the big draw of a foreclosure sale or auction. You could score a property for less than market value.
• Potential bargaining power: Banks are in the money lending and investment business, not the property owning business. They do not want to hold property for long, so you could use this to your advantage in negotiations.
• Potential investment opportunity: If you can get a distressed property cheap enough, or do a lot of repairs and renovations yourself, you could come away with a profitable rental property, or flip the house for a profit.

Cons of a foreclosure

If there was only upside to foreclosure sales, every buyer would be on them. Here are three risks you face.

• Unknown condition: Most foreclosures are sold as is. Furthermore, many times you don’t have the opportunity to conduct a home inspection before buying. The result: you could buy a lot of expensive problems that negate any lower price.
• Competition: The foreclosure market is a competitive one. At auctions or in sales, you’re bidding against other aggressive buyers. You’ll often need to make quick financial decisions with little information. It’s not for the weak of heart.
• Financing is often difficult: Foreclosures are often cash sales because financing is difficult for distressed properties that are sold as is.
• Potential liens and encumbrances: If the previous owner didn’t pay property taxes or other bills, the property could have liens or encumbrances on it that need to be cleared or understood before you get a clean title.

Where to find foreclosed properties for sale

To find listings of foreclosed properties, search bank websites, government programs, and dedicated listing services and websites. A few good places to start are Fannie Mae’s HomePath and Freddie Mac’s HomeSteps sites.

When comparing foreclosed properties, don’t just compare price. Try to get a sense of the property’s condition, any financing requirements, and other factors that could make a property more or less desirable. Reach out to the listing agent with prepared questions about the property you’re interested in.

The short-sale buying process

While a short sale resembles a typical real estate transaction in many ways, it has substantial differences. One is the timeline. Expect a short sale to take a long time, up to a year.

Short sales often happen when a homeowner is in preforeclosure due to being underwater on their mortgage. Simply put, the owner owes more than the home is worth (underwater), stopped making mortgage payments, and the lender is getting ready to foreclose. For this reason, even though your real estate agent makes an offer and works with the homeowner’s agent, the lender must approve any sale.

So, while the timeline is typically longer and each step can be more complicated, a short sale follows a typical real estate transaction. You’ll make offers and field counteroffers, find financing, and conduct the all-important home inspection, before closing.

Pros and cons of a short sale

Just like foreclosed properties, short sales have a lot of potential benefits, but some possible drawbacks as well.

Pros of a short sale

If you have the wherewithal, buying a short-sale property comes with many potential advantages.

• Potentially lower price: Short sale properties are often sold below market value, so you could potentially negotiate a great deal.
• Less competition: Unlike foreclosures or the retail real estate market, short sales tend to attract few buyers because of the added hassles and time.
• Home inspections are possible: Unlike foreclosures, you can usually arrange for a home inspection so you know what you’re getting yourself into.

Cons of a short sale

As with any potentially great deal, there are other downsides.

• Patience required: Ironically, the short sale process is typically very long. Because the lender has to sign off on any deal the seller makes, it can add months to the transaction.
• As-is condition: Just like foreclosed properties, short-sale properties are often sold in as-is condition. So they can come with a lot of repairs needed.
• Cash is king: Lenders are more likely to approve sales where the buyer has an all-cash offer or a large down payment.

Where to find short-sale properties for sale

The best way to find short-sale properties is through a real estate agent who specializes in them. Or, if you have a real estate agent, often they’ll give you access to the multiple listing service (MLS), where short sales are listed.

Compare prices, but also the condition of properties. When you find a property you’re interested in, have your agent reach out to the owner or their agent, just as you would with any other real estate transaction. The difference here is patience. Make sure you’re prepared for a possibly long process.

FAQ

How long does a foreclosure or short sale process take?

According to the Department of Housing and Urban Development, the mortgage lender will start the foreclosure process 3 – 6 months after the first missed monthly mortgage payment. After that, it could take up to a few months or even years to get the house sold.

The short-sale process from start to finish can also take anywhere from 3 – 6 months, and possibly longer, depending on the situation.

Which is better for a home buyer: short sale or foreclosure?

Short-sale homes are typically in better condition than foreclosed homes. Although short sales might have better bones, you’ll almost always save more money on the home price buying a foreclosed home. It’s important to consult with your real estate agent when thinking about buying a short sale versus a foreclosure.

Does buying a short sale or foreclosure home hurt my credit?

Going through a short sale or foreclosure can affect the homeowner’s credit score and credit report as a whole, but buying one of these homes doesn’t hurt your credit.

Are short sales and foreclosures good investment opportunities?

If you have a significant amount of money that can cover the cost of the home and repairs, you could make a large profit by purchasing a short sale or foreclosed home and reselling it.

The bottom line: Do your research before buying a short sale or a foreclosure

Foreclosure and short-sale properties can both be great opportunities to score a below-market deal on a house. But they also both come with a unique set of challenges and risks that need to be carefully navigated.

You’ll need knowledge, time, and patience to take full advantage of either process. A great first step to any real estate transaction is to get preapproved through Rocket Mortgage^®. You’ll know how much house you can afford and it could increase your bargaining power.