When a home owner/borrower either is in default or is considering defaulting, the borrower has 2 basic options.
Short sale: One choice is the "short sale" whereby the owner sells the property for market value and the creditor "bank" agrees to release its mortgage even though it is not paid in full on the mortgage note. This requires the owner to market the property (let in prospective buyers, etc), to negotiate a proposed sale, and then to seek the bank's cooperation.
Default/foreclosure Alternatively, the owner could default (stop paying) and lose the house through foreclosure. Typically, the bank serves notice and then files suit, eventually obtains a judgment, and then has a sheriff's sale after which the owner must leave.
How do these two options compare?
A short sale involves substantial cooperation between the borrower/seller and the lender. From the perspective of the borrower/seller, the short-sale approval process often is long and frustrating. The lender often gives conflicting or unclear direction as to when or whether the short sale will be approved. The lender typically requests numerous documents from the borrower such as the borrower's budget, income, expenses, wage statements, tax returns, utility bills etc. Often, the lender requests these same documents numerous times and/or in numerous different formats. The process can take an unlimited amount of time since the lender need not necessarily agree to the short sale. The short sale process is entirely a process of negotiation.
The foreclosure process, to the contrary, is a legal proceeding with timeliness set by statutes and the court. A typical owner-occupied home foreclosure typically takes 7-18 months depending upon a few key factors. At the conclusion of the process, if the lender is entitled to and obtains a judgment, there will be a sheriff's sale.
One key concept related to either option is the "deficiency." The deficiency is the amount owed to the bank less the amount received by the bank. Either option could result in the owner owing the deficiency amount to the creditor(s). However, with respect to the first mortgage debt, either option typically results in forgiveness or waiver of the deficiency. (Caution: this is not necessarily the case and is an important area for review by an attorney. Also, there may be important tax consequences to how this situation is treated.)
Contrary to conventional wisdom, according to FICO Banking Analytics Blog 2011, there is no difference in credit score damage between a short sale and a foreclosure. Depending upon where the borrower's credit started, either a short sale or a foreclosure will cause the credit score to drop 100-160 points. The time needed for the borrower's credit to recover is estimated to be the same for a short sale as for a foreclosure (3-7 years). The only difference between the two options with respect to credit score seems to be that the credit score recovery will begin earlier in the case of a successful short sale since the timeframe presumably will be shorter for a successful short sale than for a foreclosure.