A short sale in real estate is when a financially distressed homeowner sells his or her property for less than the amount due on the mortgage.
What is a Short Sale (Real Estate)
A short sale in real estate is when a financially distressed homeowner sells his or her property for less than the amount due on the mortgage. The buyer of the property is a third party (not the bank), and all proceeds from the sale go to the lender. The lender either forgives the difference or gets a deficiency judgment against the borrower requiring him or her to pay the lender all or part of the difference between the sale price and the original value of the mortgage. In some states, this difference must legally be forgiven in a short sale.
In investing, a short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future.
BREAKING DOWN Short Sale (Real Estate)
The term short sale refers to the fact that the home is being sold for less than the balance remaining on the mortgage, for example, a person selling a home for $150,000 when there is still $175,000 remaining on the mortgage. In this example, the difference of $25,000, minus closing costs and other costs of selling, is considered the deficiency.
Before the process can begin, the lender that holds the mortgage must sign off on the decision to execute a short sale, also known as a pre-foreclosure sale. Additionally, the lender, typically a bank, needs documentation that explains why a short sale makes sense; after all, the lending institution could lose a lot of money in the process. No short sale may occur without lender approval.
Short sales tend to be lengthy and paperwork-intensive transactions, sometimes taking up to a full year to process. However, short sales are not as detrimental to a homeowner’s credit rating as a foreclosure.
Differences Between a Short Sale and a Foreclosure
Short sales and foreclosures are two financial options available to homeowners who are behind on their mortgage payments, have a home that is underwater or both. The owner, in both cases, is forced to part with the home, but the timeline and consequences are different in each situation.
A foreclosure is the act of the lender seizing the home after the borrower fails to make payments. It is the last option for the lender, since the home is used as collateral on the note. Unlike a short sale, foreclosures are initiated by lenders only. The lender moves against the delinquent borrowers to force the sale of a home, hoping to make good on its initial investment of the mortgage. Also, unlike most short sales, many foreclosures take place when the homeowner has abandoned the home. If the occupants have not yet left the home, they are evictedby the lender in the foreclosure process.
Once the lender has access to the home, it orders an appraisal and proceeds with trying to sell the home. Foreclosures do not normally take as long to complete as a short sale because the lender is concerned with liquidating the asset quickly. Foreclosed homes may also be auctioned off at a trustee sale, where buyers bid on homes in a public process.
A homeowner who has gone through a short sale may, with certain restrictions, be eligible to purchase another home immediately. In most circumstances, homeowners who experience foreclosure need to wait a minimum of five years to purchase another home. A foreclosure is kept on a person’s credit report for seven years.
While a foreclosure essentially lets you walk away from your home, albeit with grave consequences for your financial future, such as having to declare bankruptcy and destroying your credit, completing a short sale is labor-intensive. However, the payoff for the extra work involved in a short sale may be worth it.
Things to Know About a Short Sale
Even though a short sale hurts a person’s credit score less than a foreclosure, it is still a negative mark on credit. Any type of property sale that is denoted by a credit company as “not paid as agreed” is a ding on a credit score. Therefore, short sales, foreclosures and deeds-in-lieu of foreclosure all negatively impact a person’s credit.
Short sales don’t always negate the remaining mortgage debt after a property is sold. This is because there are two parts to all mortgages: a promise to repay the lender and a lien against the property used to secure the loan. The lien protects the lender in case a borrower can’t repay the loan. It gives the lending institution the right to sell the property for repayment. This part of the mortgage is waived in a short sale.
The second part of the mortgage is the promise to repay, and lenders can still enforce this portion, either through a new note or through the collection of the deficiency. Regardless, lending institutions must approve the short sale, and borrowers are sometimes at their whim.
How to Go About the Short Sale Process
Before beginning the short sale process, the struggling homeowner should consider the likelihood that the lender will want to work with them on a short sale by understanding the lender’s perspective. The lender is not required to do a short sale; it will be allowed at the lender’s discretion. The source of the financial trouble should be new, such as a health problem, the loss of a job or a divorce, not something that was not disclosed when the homebuyer originally applied for the loan. The lender won’t be sympathetic to a dishonest borrower. However, if you feel you were a victim of predatory lending practices, you may be able to talk the lender into a short sale even if you have not had any major financial catastrophes since purchasing the home.
Also, be aware of other circumstances that may prevent the lender from wanting to do a short sale. Unfortunately, if you are not actually in default on your mortgage payments yet, the lender probably won’t be willing to work with you. Also, if the lender thinks it can get more money from foreclosing on your home than from allowing a short sale, the lender may not allow you to exercise this option. Finally, if someone cosigned on the mortgage, the lender may want to hold that person responsible for payment rather than doing a short sale.
If you think your situation is ripe for a short sale, talk to a decision-maker at the bank about the possibility of engaging in this type of transaction. Don’t just talk to a customer service representative, who is often more like a spokesperson and has no real authority. To work your way up the phone ladder, immediately ask to speak with the lender’s loss mitigation department. If you don’t like what the first decision-maker says, try talking to another one on another day and see if you get a different answer. If the lender is willing to consider a short sale, you’re ready to move forward with creating the short sale proposal and finding a buyer.
At this point, you should consult an attorney, a tax professional and a real estate agent. While these are high-priced professional services, if you make a mistake by trying to handle a complex short sale transaction yourself, you may find yourself in even bigger financial trouble. You may be able to pay for these service fees out of the sale proceeds from your home. Professionals accustomed to dealing with short sale transactions will be able to give you guidance on how to pay them.
To put yourself in a more convincing position to complete a short sale, stop purchasing non-necessities. You don’t want to look irresponsible to the lender when it reviews your short sale proposal.
When setting an asking price, make sure to factor the cost of selling the property into the total amount of money you need to get out of the situation. Of course, you want to sell the home for as close to the value of your mortgage as possible, but in a down market, there is bound to be a shortfall. In some states, even after a short sale, the bank will expect you to pay back all or part of that shortfall.
Gather all the documents you’ll need to prove your financial hardship to the lender. These may include bank statements, medical bills, pay stubs, a termination notice from your former job or a divorce decree. It is up to you to come up with the short sale proposal. Be aware that the lender ultimately must approve a short sale after receiving all the details because the lender is the recipient of the proceeds. Your job is to find a buyer for your home.
Once you have a buyer and the necessary paperwork, you are ready to submit the buyer’s offer and your proposal to the bank. Along with the documentation of your distressed financial status, your proposal should include a hardship letter explaining the circumstances that are preventing you from making your mortgage payments. You want to make it as convincing as possible and protect your interests while also appealing to the bank. Be careful about submitting your financial information to a lender because if it does not approve the short sale, it may use your financial information to try to get money out of you in foreclosure proceedings. If you still have cash assets, you may be expected to use them to continue making mortgage payments or to make up some of the shortfall between the sale price and the mortgage amount. An attorney experienced in completing short sales can help you navigate the details.
Because short sales can take longer than regular home sales due to the need for lender approval, they often fall through. The buyer may find another property while waiting for an answer from you. Be prepared for this possibility. If the short sale transaction goes through, consult with the IRS to see if you will have to pay taxes on the shortfall.
Also, be aware that a short sale can still affect your credit score in the sense that the months of mortgage payments you missed prior to the short sale can show up as delinquent payments on your credit report. It is up to the bank to decide what to report, so it’s in your best interest to try to convince the bank not to report your defaulted payments. Your bank may be more likely to be generous in this regard if you brought up your hardship before you were significantly behind. For credit purposes, while this is somewhat damaging, it is certainly less damaging than a foreclosure.