When the value of a home drops by 20%, it's tempting to let it go into foreclosure, or work out a short-sale agreement with the bank. But giving up a current home in the hopes of paying less on a future home may cost even more money - or put your finances in a riskier situation.

What are Foreclosures and Short Sales?
Both foreclosures and short sales involve leaving your home without selling it in the traditional manner. In the case of foreclosures, the home is repossessed by the bank, due to missed payments. A short sale happens, in most cases, when you know you can't afford your home any longer – whether payments have been missed or not.

An Example
Let's say you have $200,000 left to pay on your mortgage, and you get the bank to accept an offer from a buyer for $180,000. The bank allows this transaction to take place because selling the home now for less money may work out better for them than if costs were incurred for the bank to sell the home if you went into foreclosure.

When Foreclosures and Short Sales are Utilized
When the property value in a neighborhood decreases over time, it may be advantageous to sell at a loss – even if money is still owed on a mortgage – in order to save money in the long-term. In short, the home is now a bad investment, and losses need to be cut.

While this may make sense based on simple calculations, foreclosures and short sales have long-term credit implications that will influence many aspects of your life for years to come.

Credit Implications
Your FICO score will drop by over 100 points due to foreclosures, according to Barry Paperno, consumer operations manager at Fair Isaac. Your FICO can also drop for short sales, if the sale was reported as settled for less than what was due. This may seem like a relatively small amount for a default on a major asset, but it's enough to cause credit card companies to consider rate hikes and credit limit decreases, and for insurance companies to raise premiums. (Learn more about your credit rating in our article: Consumer Credit Report: What's On It.)

The Name Difference
The main credit difference between a short sale and a foreclosure is the name of the action that goes on the credit report. A short sale looks better to future lenders than a foreclosure. It shows you took action before the bank had to repossess your home. But either way, it still stands out as a negative on your credit report, which stays with you for at least seven years.

Buying Another Home
While the time frame you have to wait to buy another home after a short sale or foreclosure differs from lender to lender, FHA loans generally require a three-year wait following both. However, HUD spokesperson Lemar Wooley says the waiting period is evaluated on a case-by-case basis. "If, for instance, the short sale is a result of a significant decline in value and the homeowner had been making his or her payments on time, and the sale was made necessary by a job relocation," says Wooley, "that would be viewed more favorably than a short sale that was simply to speed the foreclosure process."

Of course, whether or not any lender approves you for a loan beyond the first few years after your foreclosure or short sale is also based on other factors, such as how you've handled your bills since then, if you meet income requirements and the reason for leaving the home in the first place.

Renting could also be difficult immediately following a short sale or foreclosure, as most apartment complexes will check your credit.

Employment Issues
Future employers who check your credit report will see that your home was foreclosed on, or sold short, and that could affect a hiring decision. You may even be disqualified automatically from a position, or have to explain why you chose to leave your home.

Rising Future Home Values
The absolute scariest part about taking the risk and walking away from your home is the uncertainty of future home prices and interest rates. Just as homes can go down in value, they can also go up. Then, you'll have a new house with a potentially higher interest rate and a high purchase price.

Alternatives
If you are considering a foreclosure or short sale because you can't afford your home, try adjusting your expenses. No matter why you are thinking about leaving your home, you can ask for a loan modification that will shrink your mortgage payments. (Read Squeeze A Greenback Out Of Your Latte.)

Loan Modification: Talk to your bank about adjusting your rate, so you can afford to stay in your home. You may be able to reduce your payments by securing a lower interest rate. Even if you can afford your payments, it doesn't hurt to call your bank and see if the rate can be lowered. How much can a loan modification save you per month?

Check out the table below to see how much a 1-4% drop changes mortgage payments.

30-Year Fixed-Rate Mortgage Payment Table
Interest Rate $100,000 mortgage $200,000 mortgage $300,000 mortgage
8% $733.76 $1,476.53 $2,201.29
7% $665.30 $1,330.60 $1,995.91
6% $599.55 $1,199.10 $1,798.65
5% $536.82 $1,073.64 $1,610.46

Conclusion
There are times when foreclosures and short sales are impossible to avoid. However, if you can avoid them, don't take the decision lightly. Look at all your alternatives and your future goals. You may decide that if you have the means to stay in your home, it may still work out to your benefit. (For more information on short sales and foreclosures read Short Sell Your Home To Avoid Foreclosure and Saving Your Home From Foreclosure.)

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