A short sale
is the sale of a property that is underwater on its mortgage
—which means the borrower owes more than the property's current market value. Generally, a short sale is initiated by a distressed seller as an alternative to foreclosure
. In other words, if you owe $500,000 on a property worth only $400,000, the bank may approve a short sale and allow you to sell for a lower amount.
In most cases, the homeowner has already received a Notice of Default from their lender or mortgage servicer. This starts the clock on the pre-foreclosure process, which lasts on average from 30 to 120 days but doesn't always end in foreclosure. During this time, the homeowner can reach out to the lender to request a loan modification or a short sale approval.
Short sale basics
While it is the current homeowner who sells the property in a short sale transaction, all of the proceeds from the sale are used to pay off the lender. There will still be a shortfall from the sale proceeds, which can't cover the outstanding mortgage debt. The lender can either:
- Forgive the remaining mortgage balance owed
- Pursue a deficiency judgment (in states where it is permitted).
The original borrower suffers a hit to their credit score when resorting to a short sale, but it is much less damaging than if the property went into foreclosure. The selling price of a home in a short sale is often below the average market value for comparable properties.
It’s overall more advantageous for a homeowner having trouble with their mortgage to do a short sale versus going through foreclosure. A homeowner who exits an underwater mortgage with a short sale may be able to buy another house right away; this is not the case if they have a foreclosed home on their credit report.
The lender has the final say on all short sales—they decide whether to allow the homeowner to initially pursue one, and ultimately whether to accept or reject a short sale offer from the prospective home buyer. If there is private mortgage insurance
) being paid by the current homeowner, the insurer will also have a say in the process as they are insuring the original lender against default by the borrower.
How long does a short sale take?
This greatly depends on a number of factors—especially the lender. Some lenders can approve a short sale in as little as two weeks, whereas other lenders take a year or longer. However, most short sales can be completed in three to five months.
Why would a bank agree to a short sale?
Typically, a homeowner chooses to sell their home via a short sale in order to avoid a foreclosure. While foreclosure does allow the bank or lender to take possession of a home, the process can be time-consuming and costly.
After all, the foreclosure process can take from several months to several years, costing the lender tens of thousands of dollars in legal fees and holding costs. Additionally, the lender would need to place the home on the market to sell, which involves even more time and costs. Therefore, many lenders choose to accept a loss from a short sale.
Who is responsible for the remaining balance on the loan?
This depends entirely on the agreement made between the lender and the homeowner. Unless the lender explicitly waives their ability to pursue the homeowner at a later date, the seller may be on the hook for the difference between what the home sold for versus what they owed. This is critical component of a short sale, and borrowers are encouraged to seek legal council to ensure they won't be responsible for any forgiven debt.
Short sale eligibility
Not all homeowners pursuing a short sale will be approved. While each bank has different short sale requirements, typically a bank will want to see that the:
- Homeowner is behind on payments.
- Property is underwater.
- Homeowner is experiencing financial hard times and lacks significant assets.
Again, these are not hard and fast rules. Some banks don't require the homeowner to be behind on payments or be in significant financial trouble.
Homeowners with FHA loans can be approved for short sale transactions, but they have to get approval from the Department of Housing and Urban Development (HUD). For an FHA short sale, the borrower must already be in arrears for at least 30 days. Loans with Fannie Mae as the primary lien
holder are also eligible for short sales if the homeowner meets their guidelines, which generally include being delinquent in payment for 90 days or having an immediate, demonstrated hardship.
Short sale alternatives
A short sale is simply one option of many that a homeowner can use if they are experiencing mortgage trouble. This section is going to look at 4 other options a homeowner may have instead of a short sale and explain some of the pros and cons of those options.
A loan modification happens when a lender changes the terms of the loan to make the payments more manageable.
While some banks will do this on their own initiative, most lenders modify only under the terms of the Home Affordable Modification Program (HAMP). This government program requires lenders, in certain cases, to modify mortgage terms to make it more affordable. Typically, it enables lenders to re-spread the loan over 30 years and drop the payment to a maximum of 31% of the homeowner's gross income.
Statistically, loan modifications have not proved to be a permanent solution for distressed homeowners. Although there are short-term benefits for both parties, loan modifications can still heavily affect your credit and very rarely erase inequity on the property.
Deed in lieu of foreclosure
in lieu of foreclosure, also known as a "mortgage release," is a halfway point between a short sale and a foreclosure in which the homeowner gives the property's legal title back to the lender. Most lenders will want to see that attempts have been made to sell with a real estate agent
for at least 90 days before allowing a deed in lieu of foreclosure.
While it's not the best alternative, many struggling homeowners still choose foreclosures. Depending on the state of the home, it can go through a judicial foreclosure or non-judicial foreclosure. Either way, if the foreclosure is completed, the home either reverts back to the lender or is sold to a third party.
If the homeowner still lives in the property, they can be evicted, although many lenders/new owners may try to negotiate “cash for keys” to facilitate a cleaner transition. In some cases, a foreclosure may be better for the borrower than a short sale—but overall, it is recommended only if all other options are exhausted.
If the property isn't upside down—or the owners owe more than it's worth—then simply selling the home may be a good option. This would be the best-case scenario for the homeowner. However, selling a property can be difficult if the home is not in a great condition or if there is not enough equity
to pay for a real estate agent. Additionally, any late payments missed will already be affecting the homeowner's credit, but avoiding the impact of a short sale or foreclosure on the credit report would be ideal.
The short sale process
Before you start the short sale process, you may want to talk to a real estate attorney in your area to review your situation. Although agents will be involved to facilitate your sale, they cannot provide—nor should you rely on—any legal or tax advice they offer. Each case is different, and with the legal and tax challenges, it’s important you understand what is a short sale, along with your options and consequences.
The short sale process begins with a homeowner in financial distress. They are likely behind in their mortgage payments, or have just suffered an adverse event that will make the homeowner unable to meet mortgage commitments, such as a job loss, death in the household, illness, or disability.
In addition, the home is currently underwater; the amount still owed (the outstanding principle) on the mortgage is more than the property’s current market value. This most often occurs in a housing market that is seeing declining or stagnant prices. The homeowner has no equity in the home, and limited means to pay the monthly payment, and so the homeowner may go to their lender to propose a short sale.
Step 1: Find an agent
During this step, the homeowner chooses an experienced real estate agent. Short sales are complicated, and should be assisted by an agent who specializes in these sales. Do your research and ask the right questions to find someone who will understand the caveats of pre-foreclosure and steer you clear of potential pitfalls.
Here are a few questions to start:
How long have you been doing short sales? Look for agents with at least three years' experience.
How many short sales have you been involved in? What is your success rate? If they advertise 100 percent success rate, run for the hills. Unless they’ve only done one short sale, no one is hitting that average.
Why are you the best short sale specialist for me? Look for things like accreditations, experienced teammates, and additional resources. If they've worked specifically with your lenders, even better. Also check the BBB, local real estate agent board, and online reviews for complaints and feedback as well.
Step 2: Find a buyer
A lender will typically want to see that there is an accepted offer on the property. This can be done in one of several ways. A real estate investor may work with the homeowner directly and make an offer, at which point step one and step two would be reversed. However, it's more typical for the homeowner to list the home with the short sale agent, explain the circumstances to potential buyers, and wait for an offer.
Step 3: Turn in offer and paperwork
After receiving a signed purchase and sale agreement, the homeowner must deal with the bank. Typically, the homeowner simply gives the bank permission to deal with the real estate agent directly—they don't need to be involved in every step.
The homeowner, or a real estate agent acting on their behalf, will submit to the lender what’s known as a hardship letter. This letter—really more of a presentation packet—will state the reasons and cite the evidence showing why the homeowner can’t meet their mortgage payments. Typical items included in a hardship letter package would be prior years’ tax filings, pay stubs, the original loan documents, and any large other debt burdens such as medical expenses or a court judgement affecting the ability to pay the mortgage.
The hardship letter is exactly what it sounds like: A letter that explains why you are having trouble. This letter should be written by the struggling homeowner and:
- Apologize for not being able to make the payments
- Explain how things changed between when the loan was taken and now
- Explain what you've done to try and keep up payments
- Other attempted avenues taken (loan modifications, sale, etc.)
- Detail what the offer received on the property was and why the bank should accept it
- Be cordial, polite, and detailed.
While some lenders will respond within weeks, other lenders still take months and months to respond, and there is no guarantee that the response will be helpful or positive. Patience is key during this stage! During this waiting time, the bank will typically assign one of their employees to be the "negotiator" in the transaction followed by the ordering of the valuation—which is step four.
Step 4: Bank valuation
Before the lender negotiates with the new buyer, they need to understand the value of the property. Therefore, the lender will order a valuation to determine the price.
Typically, this valuation is determined through a broker's price opinion (BPO) or an appraisal. A BPO is a semi-formal opinion from a licensed real estate broker of a property's value. An appraisal is more thorough.
Once the bank has a good idea on how much the property is worth, they will either either accept (skip to step six), deny (go back to step three with a new offer or quit), or negotiate (go on to step five).
Step 5: Bank negotiation
In a normal home purchase scenario, there may be healthy negotiation between buyer and seller over any repairs that need done to the property. Maybe the seller is willing to do a repair themselves to sweeten an offer. This will likely never happen in a short sale. There’s already a homeowner in distress here—they’re not going to have any extra cash to put toward repair work.
In fact, the bank doesn't negotiate with the distressed homeowner, but instead with the buyer. At this point, the homeowner is nothing more than a signature on the page. (However, they can reject the sale if the approval letter is not in their best interest.)
As with any negotiation, the buyer submits an offer, which will be either rejected, accepted, or changed. However, unlike typical real estate negotiations, this process can take a long time. Finally, when you have mutual acceptance between the bank and the buyer, the transaction can move forward.
Step 6: Make the sale happen
Once the paperwork is signed by all parties, the sale moves on to the title and escrow company—or the attorney's office if your state closes real estate transactions using attorneys. Expect this to proceed just like any other transaction. Closing costs
for the seller may be paid for or waived by their lender, as part of the initial approval for the current homeowner to pursue a short sale. But closing costs for the buyer will be non-negotiable, and must be accounted for in either the down payment or rolled into the loan the short sale buyer obtains to buy the property. Sometimes the lender may even put more of an onus on the buyer to cover some closing costs that would normally be paid by the seller, as they're now covering the seller’s expenses and trying to squeeze every penny out of the deal they can.
Pros and cons
For the lender
Pros: A lender who agrees to a short sale is doing so to lessen the financial blow of a foreclosure. A short sale also gives the lender a better public image, as they are seen as helping rather than hurting.
Cons: Besides the obvious loss in the note value, a short sale still requires a lot of time and fees from a lender.
For the seller
Pros: A seller who chooses to sell with a short sale can get out from an underwater mortgage, thus reducing their debt load. The seller also has the more "dignified" approach of selling the home rather than being legally evicted. Additionally, a short sale may look better on a credit report than a foreclosure, and the seller may be able to purchase a home sooner.
Cons: A short sale does reflect negatively on the seller's credit report, and any money paid to acquire the home (such as a down payment and closing costs) is lost forever. Additionally, there is no guarantee that the bank will accept a short sale, so all the work may be for nothing.
For the buyer
A buyer can often get a significant price reduction when buying a short sale. Additionally, because of the hassle, there may be less competition.
Cons: Short sales can take many months to complete, with no guarantee that the bank will even approve the sale. Thus, a buyer may waste a lot of time for no result. Also, a home going through a short sale may have significant deferred maintenance and problems.
After a short sale has been completed, there still may be additional taxes for the seller. The IRS considers any debt forgiven to be income and thus taxable. In other words, if you borrowed $50,000 and the lender forgave $40,000 of that loan, the IRS may tax you on that $40,000.
Before pursuing a short sale, talk to a qualified professional to see if you may be liable for taxes.
Buying a short sale home
Investors who become successful short sale buyers learn to get loan pre-approvals early, before ever making an offer on a house. This is always important, but critical when pursuing a short sale transaction. A lender could immediately reject a prospective buyer who doesn’t have pre-approval in place.
Many short sale opportunities will show up on standard MLS
(Multiple Listing Service
) search screens. A home that’s been approved by a lender for a short sale will have verbiage on the MLS listing such as “subject to bank approval." And properties found this way will generally have a realtor attached to the listing.
Many homeowners aren’t aware that a short sale is an option. They just think foreclosure is the only out if things get tight with a mortgage, or the value of the property has fallen substantially below the remaining balance on the mortgage. So a good strategy to find short sale deals can also be to pursue burdened homeowners directly. This includes home owners who have zero or negative equity in the home (a homeowner isn’t allowed to make a profit on a short sale, as the lender isn’t being made whole either).
Risks and rewards
The risks and “full disclosure” on short sales are prominent. Some real estate agents don’t have experience with short sales. Real estate investors or first-time homebuyers looking at short sale opportunities need an agent who’s done multiple short sales. It’s a different ballgame to be negotiating with a professional lender as opposed to an individual property seller. Find a local agent with experience and you’ll save a lot of time and headaches.
Remember, the lender holds all the cards—they can reject an offer if they think they could get a better deal. And if the lender rejects, it could take weeks or months to get back to the table or receive a counteroffer. And there’s no stipulation that the lender isn’t open to considering other offers, even if a sales contract has been signed by the interested buyer.
Another sticky situation can result if the original mortgage has been sliced off to multiple lenders, sold outright to a different lender, or there are junior liens on the property. Junior lien holders are other lenders who now have a piece of the property as collateral from a prior loan (such as a second mortgage) or from judgments against the current homeowner.
Dealing with more than one lender muddies the waters, as now a buyer has to convince multiple parties to agree to the sale, lengthening the time to get an answer. Investors who can come in with all-cash offers or very high down payments are best suited to do short sales on a property with junior liens on it. These lien holders may request a large enough deposit to cash out their portion of the debt (again, all subject to the approval of the primary mortgage lender).