What is a Short Sale?
A short sale is a real estate transaction that becomes necessary when a financially distressed homeowner has no equity in their home and needs to sell their home for less than the mortgage balance. Short sales and foreclosures are very different, and both have a lengthy process. A short sale is similar to a traditional home sale in that a seller works with a real estate agent to list their home for sale. However, the seller does not have the final say in choosing the prospective buyer, and the bank must approve any final sale price. The foreclosure process takes more time and is much more complicated, and it usually requires a lengthy court battle. We will give you a broad understanding of a short sale and the pros and cons of short sales.
How Does a Short Sale Work?
In simplest terms, a short sale happens when a borrower experiences hardship and falls behind on their mortgage payments. As a result, the borrower can no longer afford the house and asks the mortgage lender to accept less than what is owed to settle the mortgage loan in full. Usually, these homes are underwater. Underwater means the mortgage balance is higher than what the house will sell for on the open market.
Banks are motivated to pursue short sales to mitigate their losses on non-performing loans. However, the short sale process can be very time-consuming and complicated. The period of time for a short sale to close may be up to a year or more. The housing market will also play a factor in the time it takes for a short sale to close. When the market is hot, you will have more buyer activity, and short sales have a higher probability of getting bank approval if the short sale request is submitted with an offer. A series of events must take place during a short sale. First, the borrower must submit a short sale package to the lender, including a hardship letter and other documentation like bank statements, pay stubs, and tax returns. These documents will validate the borrower's financial situation and why the seller cannot fully repay the mortgage. Most lenders will only allow a short sale if the homeowner has a legitimate financial hardship.
After submitting the short sale package to the lender, the real estate agent will list the house on the open market. Next, the real estate agent will list the house on the Multiple Listing Service to ensure the house gets the most exposure to potential buyers. Next, the sales price of the short sale property will be determined by using a Comparative Market Analysis or Brokers's Price Opinion. Finally, the house must be sold to a third party for fair market value. This is known as an arms-length transaction in the real estate market. Before a short sale is allowed to proceed to closing, the bank will evaluate the offer and decide if they want to accept it.
After receiving lender approval, the closing is scheduled. In the closing statement, the lender will detail the transaction terms, including what the mortgage payoff amount will be. The lender will usually cover most closing costs and real estate agent commissions. The short sale proceeds will go directly to the mortgage lender to satisfy the remaining mortgage debt.
After the mortgage balance is paid, subsequent liens attached to the house will get paid. However, if the sale of the real estate doesn't cover the remaining mortgage balance, the bank is allowed to pursue the borrower for a deficiency judgment. A deficiency judgment is an unsecured money judgment against a borrower whose short sale did not produce sufficient funds to pay the underlying promissory note or loan in full. To give you an example, if the borrower owes the mortgage company $200,000 for their house and a short sale buyer buys the house for $100,000, the bank can pursue the borrower for the remaining $100,000 that wasn't satisfied upon the sale of the house. Deficiency judgments will be contingent on if the original mortgage loan was recourse or non-recourse. If the lender seeks a deficiency judgment against the borrower, the borrower will be required to repay the difference between the sale price and the original mortgage. In addition, the borrower must seek a deficiency waiver from the lender or mortgage servicer. A deficiency waiver stops the lender from pursuing the borrower for mortgage debt that wasn't satisfied during the real estate transaction.
It is also possible that mortgage debt that was forgiven during the short sale can be taxed as income. Therefore, it is imperative for homeowners involved in a short sale to seek legal advice from a real estate attorney and certified public accountant regarding the implications that can arise from a short sale transaction. Also, keep in mind that the short sale process may vary slightly from lender to lender.
What are the Benefits of a Short Sale?
The main advantage of a short sale transaction for the borrower is the relief from the mounting debt accumulated from missing mortgage payments. Every time a borrower misses a payment, the unpaid mortgage balance will carry over into the new month. This results in the mortgage payments getting so high that the borrower can never catch up.
The borrower's credit is also negatively affected by the missed payments. If the borrower has no foreseeable way to make the monthly mortgage payments, it may make sense for the borrower to sell the house to mitigate the damage to their credit score and avoid foreclosure. Some lenders even offer relocation assistance to help borrowers make an easier transition to their new destination.
A house with equity may not need a short sale as the house will satisfy the remaining mortgage debt. Peace of mind comes from removing an insurmountable debt from your life. Short sale properties usually suffer from deferred maintenance. Many of these homes will not pass an FHA inspection due to their state of disrepair. This will limit the buyer's pool. These homes are usually attractive to real estate investors with cash and seek homes that need renovation.
Short Sale vs. Foreclosure
A short sale has fewer financial consequences for the seller than a foreclosure. Homeowners who have fallen behind on their monthly payments and whose properties are underwater can consider a short sale as a financial option. Foreclosures and short sales have different timelines and consequences. Short sales tend to be preferred by homeowners over foreclosures because they are voluntary, whereas foreclosures are forced. Lenders also prefer short sales because they can recover a more significant amount of the original loan than foreclosures without an expensive legal process.
As the primary lien holder, the lender has the authority to repossess a mortgaged home if payments aren't made. The short sale process can be used as a way for homeowners to avoid foreclosure before they stop making payments. If the lender has already begun the foreclosure process, in some cases, the borrower may still be able to enter into a short sale. One of the most common misconceptions of short sales is the timeline of missed payments. Most people think borrowers need to be in foreclosure before initiating a short sale. This is not true. A bank can approve to pursue a short sale after one to two missed payments. The amount of delinquency will vary by the mortgage company.
Most lenders will only pursue foreclosure if they have first attempted to sell the property via a short sale. Foreclosures occur when a borrower fails to make payments on a mortgage, and the lender is forced to take ownership of the property. This is the last resort for the lender. A foreclosure will negatively affect the borrower's credit score for seven years. Short sales usually come off the borrower's credit report in two years. A borrower's credit score has the potential to go up over 100 points after a short sale is deleted from their report. This can be a huge determining factor in the timeline of a borrower looking to get another loan in the future.
Short sales have their advantages for sellers, lenders, and buyers. Borrowers who have fallen on hard times can use short sales as an alternative to foreclosure. For buyers and sellers, the waiting period can be extensive. However, the best things come to those who wait. An experienced real estate agent can help you determine a fair offer, negotiate with the bank, and maneuver around the other nuances of short sales.
Lenders win, too, because they can recoup their non-performing investments and lend them out again to accrue more interest. The longer a lender doesn't receive payments on a loan, the more money it loses. The foreclosure process can take several months, even more than a year, to complete, costing the lender thousands of dollars in interest. In addition to missing out on monthly payments, foreclosing on a home is an expensive legal process. So if going with a short sale allows the lender to recover more money, it makes financial sense. The benefit to the lender is that a short sale is faster and less expensive for them than a foreclosure. Once it's clear a foreclosure will be unavoidable, a lender is more likely to approve a short sale request.
A short-sale property can provide an excellent opportunity to purchase houses for less money. In many cases, short-sale homes are in reasonable condition, and while the purchase price might be higher than a foreclosure, the costs of renovating the home can be much lower. While many investors purchase short-sale properties and quickly resell them for a profit, others may choose to maintain ownership and use the properties for rental income.