In a short sale, the mortgage lender agrees to let a homeowner accept an offer for their home that's less than the amount owed on the loan. The bank takes all the proceeds, but the seller walks away with the remaining debt forgiven.
Choosing to go that route will put a serious dent in your credit score, but it's not a fiscal death sentence. You can rebuild your credit and your finances after a short sale.
Immediately After a Short Sale of Your Home
In many cases, banks and lenders view a short sale as the equivalent to a foreclosure. Credit bureaus and future lenders consider it similarly to a default on your mortgage. The three major credit bureaus list it on your credit reports for seven years, but you can take steps immediately after a short sell to help restore your financial profile.
"You should regularly pull your free credit reports through AnnualCreditReport.com," says Todd Christensen, director of education for the National Financial Education Center. "For someone who is rebuilding their credit, they could consider accessing one of their three available reports every four months in order to check for accuracy in addition to any unfamiliar or fraudulent activity."
Another critical task is to ensure that your loan balance has been forgiven. If it hasn't been, you could find a collection company coming after you. Be aware, you also must claim the forgiven debt as income when you next file taxes.
Building and rebuilding credit is like the fable of the tortoise and the hare: Slow and steady wins the race. The short sale has less of an impact on your credit score each year after the event.
One to Four Years After a Short Sale
In those first few years, focus on small financial victories. "A simple and free way to begin the credit rebuilding progress is, first to ensure all utility, cell phone contracts and Internet provider payments are made on time and in full," says Christensen. Ask these companies if they report your on-time payments to at least one of the three major national credit bureaus. He says they're not typically required to do so, but they often will if asked.
The credit bureaus don't give utility and cell phone payments as much weight as good credit card stewardship, but they will help move the needle. And every little bit helps.
You may also find that without notice, other creditors will lower your credit limit after your short sale. Wording giving them that option is often included in the fine print of the contracts and user agreements of credit cards and other debt. Don't let that be a reason to make any more damaging credit moves.
"Keep paying bills on time, avoid applying for new credit, and don't close credit card accounts," says Miranda Reiter, a certified financial planner at She & Money Financial Planning. "You'll want to keep the cards open so that as you pay down your balances, your debt to credit available ratio is lowered, which improves your score."
Good budgeting can be one of your most vital tools in the years following a short sale. With a damaged credit score, you may find yourself with little to no ability to depend on credit cards as a backup plan. So it's doubly important that you work to build up a solid emergency fund and prepare a written monthly family budget.
Several Years After a Short Sale
If you do not have many open accounts after a short sale, you may want to try rebuilding your credit score by applying for a secured credit card. You may also be able to find a small loan offed by a bank or credit union in your area that specializes in helping to build up your credit.
"A secured card is one in which you put up a certain amount on deposit that you cannot access," says Cara Pierce, a housing financial specialist with ClearPoint Credit Counseling Solutions. "The lender in turn gives the borrower a credit card with a limit in the same amount of the deposit."
You're not entirely out of luck if you'd like to try again as a homeowner, either. In many cases, you do not have to wait the full seven years it will take for the short sale to vanish from your credit report before you can buy another home.
"If you were current on your mortgage payments and also did not have a job loss, you can apply for a VA loan two years after selling a home in a short sale," says Phil Georgiades, chief loan steward for VA Home Loan Centers. "You can also apply for a FHA mortgage three years after a short sale and a conventional mortgage four to seven years after your short sale."
Have you experienced a short sale? How big of a hit did your credit score take? What steps did you take to help rebuild your credit?
Hank Coleman is the publisher of the popular personal finance blog Money Q&A, where he answers readers' tough money questions. Follow him on Twitter @MoneyQandA.