Image: House for sale © Ocean, Corbis

Arranging a successful short sale takes a lot more effort than simply letting your home slide into foreclosure. So why do your credit scores have to suffer so much?

That’s the question people typically ask when they learn that the leading credit scoring formula, the FICO, treats short sales and foreclosures as essentially the same, said Barry Paperno, the community director for Credit.com.

A short sale is when a lender agrees to accept less than the homeowner owes on a mortgage. Someone with an excellent FICO score of 780, for example, could see 140 to 160 points chopped off that score with either a foreclosure or a short sale, according to the company that created the score. Recovery from either blow could take seven years.

The issue of this major credit-score dip is affecting more people as banks approve more short sales. In fact, there were more short sales than sales of bank-owned homes in the third quarter, according to real estate research firm RealtyTrac. Sales of so-called pre-foreclosure homes jumped 22% compared with the same period a year earlier, and short sales made up 65% of those sales, RealtyTrac said. Short sales of homes that haven’t entered the foreclosure process also rose 22% compared with the third quarter of last year.

Short sales can benefit both lenders and borrowers:

  • Short sales can be better for lenders, since the sale price may be more than the home could fetch after foreclosure. Also, they allow lenders to avoid the often long and costly legal process of eviction.
  • Short sales have benefits for borrowers, too, since a short-sale agreement can prevent a lender from suing a borrower over unpaid debt.  These so-called deficiency judgments are otherwise possible after a foreclosure in many states.

Short sales still aren’t easy. Agreements can take months to negotiate, and many fall through. A successful deal usually requires a tenacious and persistent homeowner.

So, shouldn’t that behavior be rewarded?

There you have the crux of the problem. The FICO formula is, essentially, amoral. It wasn’t built to reward or punish, said Frederic Huynh, FICO’s senior scientist. Instead, he said, it was constructed to predict the likelihood that a borrower will default on a credit obligation within the next two years.

Interestingly, FICO formula creators didn’t have a lot of experience with short sales when they decided to treat them the same as foreclosures, said Paperno, who worked at FICO for 16 years before joining Credit.com. Until recently, short sales were relatively rare.

But FICO published research this summer, based on analysis of credit report data from people who fell behind on their mortgages from 2007 to 2009, which confirmed that most people who have a short sale or a foreclosure on their records later default on at least one other credit account.

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“They did the research later,” Paperno said. “The good news for FICO is the data supported it.”

The rates of default differ considerably, at least to civilian eyes. The FICO research showed 72% of those with a foreclosure later defaulted on another debt, compared with 55.1% of those with a short sale and 50.1% of those who arranged a deed in lieu of foreclosure, which means they voluntarily surrendered their keys to the bank rather than going through formal foreclosure.

So borrowers who were more proactive were significantly less likely to default than those whose homes were lost to foreclosure. Nonetheless, FICO views a one-in-two chance of default as exceptionally high risk.

“That’s pretty high,” Paperno noted. “It can be a lot lower and still not be a loan you would want to make.”

FICO hasn’t been moved in the past by arguments that things are different this time. It didn’t alter its formulas after the huge wave of foreclosures in recent years, though many more people lost their homes because of economic circumstances beyond their control. If FICO’s research shows people are more likely to default after a certain event, that event will continue to have an impact on scores.

Since FICO won’t listen to your pleas for leniency, you’ll need to take matters into your own hands to rebuild your scores. That means you should:

Defy expectations. Be among the 45% of people who don’t default after a short sale. That won’t change the initial impact of the short sale on your scores, but staying current will keep you from suffering more damage.

Use credit cards lightly but regularly. Using credit cards can help rehabilitate your scores, but you don’t need to carry a balance or pay interest. Charge small amounts to your cards and pay them off in full every month. Try to use 30% or less of your credit limits at any given time. If you don’t have a credit card, you can start with a secured card that gives you a credit limit equal to the deposit you make with an issuing bank.

Consider an installment loan. An open, active installment account, such as a student or auto loan, can help you build up your scores if you make every payment on time. If you don’t have such an account, consider taking out a small personal loan from a credit union or bank that reports to all three credit reporting bureaus.

Don’t shoot yourself in the foot. There are plenty of ways to hurt your scores inadvertently. These include closing accounts, applying for a bunch of new accounts in a short period and letting a dispute or medical bill fall into collections. If you use the diligence you applied to the short sale process to monitor your credit accounts, you should be able to restore your good scores within a few years.

Click here to become a fan of MSN Money on Facebook

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.

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