Bankruptcy vs Short Sale….Or Both?

by The Real Estate Faction on January 26, 2011

As a foreclosure advocate, I get this question a lot. Often its because the person has received some advice from an attorney, or a friend that they trust. They are essentially assuming that a bankruptcy is as bad if not worse than a foreclosure so if your credit cant get worse, whats the point. Its like being a little bit pregnant.

This advice is very typical of most bankruptcy attorneys I’ve worked with in the last 10 years. In fact I was doing a little looking around the Internet for other people’s thoughts on this and found a video on you-tube where an attorney is taking the position that short sales are ‘trouble’ (shocker) and its not really worth worrying about.

Oddly he claims there are two kinds of short sales, one where you get stuck with the debt anyways, and one where you don’t. This is a pretty strange analysis, as there is only one kind of short sale; The kind where the bank doesn’t get all their money.

If you are a homeowner faced with this question the quick and dirty version is there are 3 different results that can come from doing a short sale. I talk about them in this article, however, this article isn’t intended to address these 3 results, this article is about people in bankruptcy so the 3 results don’t apply, but, I do intend to write an article that addresses this problem for anyone not doing a bankruptcy in conjunction with a short sale.

Now the reason attorneys think this way is because…well, they are attorneys. They are taught to think this way. Their job is to help people stay out of trouble, and short sales are a bit complicated and require professional help. I often equate it to open heart surgery…ok its not that tough, but it is something that should only be trusted to experts with verifiable experience.

Also some attorneys try to avoid as much work as possible, and since they would have to file a couple of extra documents to help their client do a short sale, well its just easier to discourage it (I’m sure I’m going to catch hell for that comment O.O) I’m totally kidding all you attorneys reading this…kind of.

The second reason attorneys think this way is because attorneys don’t care about your future credit. Well, let me rephrase that…they don’t have any incentive to care; I don’t mean to imply they are heartless, and some Attorneys might actually care about your credit. But if someone has just helped you destroy your credit by filing a bankruptcy, in their mind doing a short sale after or during a bankruptcy is a bit like tagging a band-aid on the titanic. Too little too late as they say.

They also are typically only looking at it from a legal perspective, meaning because of the bankruptcy you are no longer responsible for the debt, so they are correct that its a bit pointless to do a short sale if all you are worried about is owing any deficiency.

This however is a short sighted mindset, as it only takes into account the present at the expense of your future. They are essentially saying that it doesn’t matter because the mortgage company cant try to collect the debt. But the most relevant question you should ask yourself is, do you want to buy a home some time in the future? If so, this decision is more important to consider than most bankruptcy Attorneys, and their clients might think.

When facing financial hardship, you can save yourself valuable time and avoid stress if you begin looking immediately at how to rebuild your credit and financial health. Don’t wait for the aftermath, or worse, waiting years later to begin planning your path back to good credit and home ownership.

Doing a short sale, even if you are in a bankruptcy is a huge step in the right direction if you plan to rebuild your credit and own a home again some day. At the very least it will keep your wait under current mortgage guidelines to 24 months as opposed to 5-7 years.

I called a friend today who happens to be a bankruptcy attorney, and I asked him this question. “Can you tell me one reason that its better for someone to not do a short sale if they are going to file a bankruptcy?” he gave me two answers, and they are very telling.

His first answer was “sure, there are several reasons”. He went on to explain that sometimes people are at an emotional point where they just cant handle any more stress and just want a clean start.

This might seem fair enough, however, In my opinion, this really only answers issues of mental and emotional well being rather than the more technical question of how it affects you and your credit in the future.

I mean, If you are on the verge of a mental breakdown, then just do what you need to do in order to feel well. I get that, really I do. It is after all just a house, but lets throw out those individuals and look at people who aren’t dangerously close to the edge of losing it;

So I said “Ok, but what about everyone else?”

His answer was “yeah, I cant see any logical reason not to do a short sale even if you are already in a bankruptcy.”

Now, I am not calling this the end all be all of opinions, nor is this legal advice. *You should legal advice from an attorney who specializes in bankruptcy and foreclosure matters (even though he is probably going to tell you that there is no reason to do it, but you will know better after having read my article)

So let me recap what he is saying in plain English for people like you and me. Sometimes its a mess and people are filing a bankruptcy to move on with their life. They want the mess behind them. They want the proverbial ‘clean slate’.

BUT if you factor in the long term goals of most people, like owning a home, it makes sense to do everything you can to ensure you have a clean credit file. Short sales look better on your credit in the long run, but sometimes people just cant deal with more stress, thats just how it is and they will simply deal with the resulting consequences later when they are in a better state of mind.

It should be noted here, because I’m sure some guy that’s been doing short sales, or mortgages or selling Hyundai’s for a tenth of the time I have…(I’ve never sold Hyundai’s, just the other stuff) will make some comment about how despite my opinions short sales are still a negative item on your credit.

He would be correct, its just like settling a credit card for less than you owe, it will most likely report on your credit that you did not fully pay the debt. Sometimes we are successful at getting the lender to report it as paid in full, but you shouldn’t rely on that as any kind of a certainty…if it happens its a nice bonus, but don’t plan on it. So it is BAD, but it IS NOT as bad as a foreclosure nor is it as bad for as long as a foreclosure.

By law, foreclosure stays on your credit for 7 years. Bankruptcy also remains 7 to 10 years depending on what chapter you file under. The major CRA’s or Credit Reporting Agencies such as Trans-union, Experian and Equifax do not release to the public how they calculate credit scores, however there are ways out there to simulate how events like bankruptcy and foreclosure factor in to your score, and typically a settled account such as a short sale or a credit card settlement, will affect your credit score negatively for 12 months. After that first year these simulators suggest that the negative impact begins to greatly diminish.

What we do know for sure is that the time to get a mortgage after a short sale is less than it is after a foreclosure. So often the argument about how it affects your credit score is a pointless issue because the majority of people are more concerned with the question of when they can own a home again. Because of this the waiting periods to get a mortgage after a short sale that are imposed by the mortgage industry are really the most important relevant issues to any homeowner.

Now that we understand the perspective that attorneys have, and why they often recommend not doing a short sale, lets look at how we can determine for ourselves if a short sale is the right choice.

The way to determine if you should do a short sale while in bankruptcy is to ask yourself this one simple question; Even though my credit is going to be damaged now, do I want to own a home again sometime in the future?

If the answer is yes, then you should seriously consider the idea of doing a short sale regardless of a bankruptcy filing.

As a mortgage professional, I feel there are several good reasons that you should consider a short sale over letting it go to foreclosure. For instance most lenders require 24 months from a foreclosure before you can get a mortgage.

*UPDATE*

[As of 2008, Fannie Mae and Freddie Mac are now indicating that they will have new guidelines for those who have had a foreclosure or a short sale. The statement says:

Fannie Mae

  • will now prohibit foreclosed borrowers from getting another mortgage through the giant investor for five years
  • If there are “documented extenuating circumstances.” the mortgage prohibition is for three years.
  • After five years, borrowers with foreclosures in their files will have to put at least 10 percent down and need minimum FICO credit scores of 680.

Freddie Mac

  • will now prohibit foreclosed borrowers from getting another mortgage for seven years
  • The company also claims they will “aggressively pursue walkaways to preserve our deficiency rights” where permitted by state law.

While they have not indicated yet what the rules will be for a short sale, in the past they have been as much as half the waiting period for a foreclosure. Previous guidelines called for a 1 year waiting period before a mortgage could be obtained after a short sale.

It is important to remember that there are two aspects of your credit to consider when determining whether or not to go through with a short sale. These two aspects are the FICO score impact and underwriting guidelines and how they will affect your ability to get a mortgage.

Despite the fact that the FDCPA or Fair Debt Collections Practices Act requires that all debts included in a bankruptcy be reported on your credit report as “included in bankruptcy”, there is a second place that a foreclosure shows up on your credit report; Public Records.

So you have the mortgage company reporting on their line that the loan was foreclosed, and then you have the foreclosure itself showing up in the public records. This will remain on a credit report for 10 years.

Knowing what has happened in the mortgage and banking world starting in 2007 through the present, its likely that lending criteria will continue to become more strict as banks look to avoid repeating the mistakes of the past 6-7 years. Because of the tightening of credit and increasingly strict lending standards its more important than ever that people consider the implications of their choices as they go through financial difficulties such as bankruptcy and foreclosure.

Credit:  http://hubpages.com/hub/Bankruptcy-Attornies-vs-Short-Sales-To-Short-or-not-to-Short

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