A short sale may be an alternative to foreclosure if you're underwater on your mortgage and looking to extricate yourself from the situation. You find a buyer for your house, usually at a bargain price. If the lender accepts the offer, it gets some of its money back and you walk away free and clear. However, the lender may not accept the offer, or may sue you for any remaining debt. Even if the sale goes through, it may not be much better for your credit than a foreclosure.
A short sale can make life easier for your lender than foreclosure. Foreclosures often drag on for more than a year, during which the house is just dead weight on the lender's balance sheet. A successful short sale wraps things up quicker. In the credit-reporting systems underwriters use, however, the same numerical code refers to both foreclosures and short sales. If an underwriter sees the code in your file after the short sale, he can't tell you weren't foreclosed on.
The federal government's Fannie Mae and Freddie Mac corporations both invest in the mortgage market to keep it healthy. Both corporations, as well as the Federal Housing Administration, treat you differently if you have a short sale on your record than if you have a foreclosure. Foreclosures are a red flag on your next mortgage application, but short sales are not. When the bank underwriter records a short sale as a foreclosure, that can disqualify you for a mortgage you'd otherwise be able to get.
Even if your lender comes out better off because of the short sale, it's still listed by the credit bureaus as a debt that you didn't pay off. Your lender reports it as an account you've settled rather than paid and reveals that you still owed money the lender had to write off. This isn't much better for your score than foreclosure.
After seven years, your short sale won't show up at all. The law says credit bureaus have to purge negative items from your history when they're that far back, except for bankruptcy which stays for 10 years. Even before then, you can rebuild your credit score by managing your credit carefully and paying debts promptly. If you want an FHA or Fannie Mae mortgage, however, even a great credit score may not overcome the negative blow of a short sale.