The year was 2007. The U.S. stock market continued its record-breaking uphill climb. Unemployment was at a six-year low. And home prices across America were surging ever higher. In the hottest real estate markets, house "flipping" was all the rage. Despite high interest rates on mortgages, investors bought up single-family homes, apartments and townhouses and sold them within months for a hefty profit.
In the mad rush to cash in on the real estate boom, millions of Americans signed mortgages they couldn't afford, often encouraged by unscrupulous lenders. The logic was tempting: "Don't worry that your mortgage rate will double in two years, because you will sell this place in less than one." In the golden haze of 2007, that argument made sense. If only we could have predicted what happened next.
When the real estate market imploded in 2008, home values plummeted. Suddenly, the investment home you bought for $500,000 at the peak of the housing boom was worth only $250,000. Even if you could find a buyer at $250,000, you would still owe another $250,000 to your mortgage lender. That's called being underwater or upside down, when the balance on your mortgage is higher than the value of your home. Sadly, the most common result is defaulting on the loan. In 2009 alone, 2.8 million homes went into foreclosure, a 120 percent increase over 2007 [source: National Association of Realtors].
Foreclosures aren't the end of the world, but they can inflict serious damage to your credit score. Federal programs like the Home Affordable Refinance Program (HARP) offer assistance to underwater homeowners looking to refinance their mortgages, but not everyone qualifies. For more and more upside down borrowers, the best option is to attempt a short sale.
In real estate, a short sale means buying or selling a home for less than the balance owed on the mortgage. To do this, the seller has to convince the mortgage lender to forgive or cancel the unpaid debt. If approved, the benefits of a short sale include:
- Fair market price for the buyer
- Seller avoids foreclosure
- Mortgage lender recuperates some of the loan principle and avoids costly foreclosure process
Sounds easy, right? Not so fast. Short sale transactions are very complex and can take months to win approval. Even if the buyer and seller agree on a fair market price, the lender can deny the request for a number of reasons. Keep reading for a step-by-step explanation of the short sale process, the pros and cons, and some tips for a successful short sale experience.
The Short Sale Process
To simplify things, let's walk through the short sale process from the prospective of the buyer. As a buyer, the first step is to find short sale listings. Short sales are rarely listed as such, because they can't be approved until there's an offer on the table. Instead, sellers use euphemisms like "pre-foreclosure," "third-party review required" or "subject to bank approval" [source: Freddie Mac]. A good place to start is the pre-foreclosure section of a Web site like RealtyTrac, which carries listings in all 50 states.
Once you have a few listings in mind, compare the prices of similar homes in the area, especially those that recently sold. That gives you a better idea of the fair market value. With a price range in mind, the next move is to get a mortgage preapproval letter from your lender. As a buyer, this will not only lock in an interest rate for homes in your price range, but also show the seller's bank that you are a serious buyer.
When you find the home you want, the next step is to make an offer. As a buyer, you will sign a purchase contract for what you and your real estate agent believe is a fair market price. You will also be asked to supply earnest money, a refundable cash deposit that once again shows your commitment to buy.
In a traditional home purchase, this is where buyer and seller negotiate and arrive at a final purchase price. But that's not the case in a short sale. In a short sale, it's the seller's mortgage lender that needs to approve the sale price.
For that to happen, the seller first needs to prove that he or she cannot afford to pay the mortgage and that a short sale is the only option to avoid foreclosure. Required documents include:
- Hardship letter with income statements and monthly expenses
- Any foreclosure notices received
- Proof that other loan modification efforts have been denied
The mortgage lender will then take weeks or months to consider the short sale [source: Toy]. During this time, it will seek approval from investors who bought the mortgage debt and conduct its own appraisal of the property value [source: Bank of America]. The bank might respond with a counteroffer or deny the short sale for a variety of reasons, including [source: Freddie Mac]:
- It believes the seller can afford pay the mortgage.
- It decides that it can recuperate more money from the seller's private mortgage insurance.
- The offer is below the fair market value of the home.
If approved, the short sale will continue like a traditional home purchase with a closing. Keep in mind, though, if the home has a second mortgage, a home equity loan, or other liens on the property, this process will have to be repeated for each lender. Yikes.
Advantages and Disadvantages of Short Sales
The most significant advantage of a short sale is that the seller can avoid foreclosure. With a foreclosure in your credit history, you have to wait at least seven years before another lender will even consider you for a mortgage, whereas a short sale only puts you on the blacklist for as little as two years [source: Weston].
Contrary to popular belief, however, short sales aren't any better for your credit score than a foreclosure. According to Fair Isaacs, the company that calculates the FICO credit score, both short sales and foreclosures will cut a 780 credit score by 140 to 160 points [source: Gaskin].
The biggest advantage for the buyer is a chance to buy a home at slightly below the fair market value without having to enter the risky foreclosure market. With a foreclosure sale, there are a number of potential nightmare scenarios, including unpaid liens on the property and owners who fight eviction [source: White].
The biggest disadvantage for the buyer is time. Short sales take much longer than a traditional home sale because the seller's mortgage lender has to give the green light. This process gets even longer if there are multiple mortgages and liens involved. Even when all of the paperwork is in order and both buyer and seller agree on a price, there is no guarantee that the lender will approve of the short sale. Buyers need to be prepared for a long and uncertain process that could end in disappointment.
Another potential disadvantage for the buyer is higher closing costs. For example, in a traditional home sale, the seller is responsible for paying for a home inspection and any related repairs. In a short sale, the seller's mortgage lender feels less pressure to negotiate, so those costs are often shouldered by the buyer [source: Freddie Mac].
At the end of the day, both the buyer and seller hope that the mortgage lender sees the advantage of a short sale over foreclosure. Foreclosures, it turns out, can be costly for lenders, too. Lenders have to take care of the maintenance of empty homes, which might include expensive repairs in addition to regular upkeep like cutting the lawns and shoveling the driveways. Lenders might also have to pay back taxes on the homes and cover the cost of auctioning or selling them [source: Guerra].
Now let's look at some expert tips on buying or selling a home through a short sale.
Tips for a Successful Short Sale
The first buyer tip for a successful short sale is to use a real estate professional with short sale experience [source: Freddie Mac]. Short sales are complex real estate transactions that require a deep understanding of determining fair market value, how lenders work and what they need to see before they approve a short sale.
In general, avoid homes that carry multiple mortgages and liens on the property. Every additional lender will add months to the approval process and decrease the chances that the deal will ultimately go through. Save yourself some heartache and stick to the properties with only one mortgage lender.
Don't make a lowball offer [source: Toy]. The best you can expect on a short sale is a price slightly below the established fair market value. Remember, the lender is already taking a loss on a short sale, so he's in no mood to be making deals. Keep all offers within a range of comparable sale prices in the neighborhood.
Show that you're a serious buyer. Come with your mortgage preapproval letter and a sizable earnest money deposit, as well as your purchase contract and comp information to demonstrate your offer is realistic [source: Freddie Mac]. The bank will be more likely to approve a sale with a fully committed buyer.
Don't attempt to cheat the system by buying a short sale home from a friend or relative and renting the house back to them. That's illegal according to the rules of arm's length transactions. In real estate, the sales price must be determined by fair market value, not a "friendly" arrangement between two relatives [source: Investopedia]. A short sale between two family members or close friends will not be approved.
Submit all paperwork and documentation in a timely fashion, whether you are the buyer or seller. There is a certain amount of bureaucracy with any real estate transaction (if you've ever attended a closing, your wrist probably still hurts from all of the documents you signed). Short sales add an additional layer of documentation, particularly to prove hardship.
Sellers, be aware of the tax implications of a short sale. In most cases, the IRS treats canceled debt as income. If your lender forgives the $100,000 balance that you owed on your mortgage, the Internal Revenue Service will tax that $100,000 as income. There are exceptions to this rule if the home was your principal residence or you were financially insolvent before the debt was canceled [source: IRS]. Either way, it seems like a good time to call your accountant.
Author's Note: How Short Sales Work
Every time I read about the millions of American homes in foreclosure and the damage inflicted by defaults and bankruptcies, I say a silent prayer of "thanks" to my buddy Sean. Back in 2005, my wife and I considered buying an investment property in Boise, Idaho. At the time, home prices across the western U.S. were skyrocketing. My brother-in-law had just cashed in on a place in Arizona and was convinced that Idaho was poised to explode.
In the dead of winter, we drove around suburban Boise with a real estate agent who was equally convinced of the city's prospects as the next Phoenix or Las Vegas. We found a modest two-bedroom in our price range with long-term renters. Before we knew it, we had signed an offer and handed over $1,000 in earnest money. While we waited for the seller to respond, we visited our friend Sean in nearby Salt Lake City, Utah. As we shared the exciting news of our pending plunge into real estate investment, Sean calmly took out a pen and paper.
He wrote down a few key figures, notably the difference between our rental income from the property and our monthly mortgage payment. Then he sketched a best-case scenario for how much property values would increase over the next two years. He reminded us that we would owe a 25 percent capital gains tax if we sold the home as an investment property rather than a principal residence. At the end of his calculations, we realized that home prices would have to skyrocket 10 percent or more per year for us to make a profit on this place.
Minutes later, our real estate agent called to say that the buyer had accepted our offer. We were the proud owners of a house in Boise! The only way out would be to sacrifice our earnest money. We call that our $1,000 class in Real Estate 101. Thank you, Sean. Without you, we'd be the proud upside down owners of an underwater property in Boise.
- Bank of America. "Traditional Short Sale Process." (Oct. 16, 2013) http://homeloanhelp.bankofamerica.com/en/short-sale-process.html
- Consumer Financial Protection Bureau. "What is a 'deed-in-lieu of foreclosure?'" May 15, 2013. (Oct. 16, 2013) http://www.consumerfinance.gov/askcfpb/291/what-is-a-deed-in-lieu-of-foreclosure.html?gclid=CJD1wrXFm7oCFcZlOgod_wIAxw
- Gaskin, Joanne. "Research looks at how delinquencies affect scores." FICO Banking Analytics Blog. March 24, 2011. (Oct. 13, 2013) http://bankinganalyticsblog.fico.com/2011/03/research-looks-at-how-mortgage-delinquencies-affect-scores.html
- Guerra, Tony. "Basic Foreclosure Fees & Costs." Demand Media. (Oct. 16, 2013) http://homeguides.sfgate.com/basic-foreclosure-fees-costs-61248.html
- Freddie Mac. "Buying a Short Sale Property: FAQs" (Oct. 16, 2013) http://www.freddiemac.com/purchasemarket/ssfaq.html
- Investopedia. "Arm's Length Transaction." (Oct. 16, 2013) http://www.investopedia.com/terms/a/armslength.asp
- IRS. "The Mortgage Forgiveness Debt Relief Act and Debt Cancellation." (Oct. 16, 2013) http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation-
- National Association of Realtors. "Record number of foreclosures in 2009." Jan. 14, 2010. (Oct. 16, 2013) http://www.realtor.org/rmodaily.nsf/pages/News2010011404
- Toy, Vivian S. "The Roller-Coaster Ride Called a Short Sale." The New York Times. July 23, 2010. (Oct. 16, 2013) http://www.nytimes.com/2010/07/25/realestate/25cov.html?adxnnl=1&pagewanted=all&adxnnlx=1381935362-xblL0Av8FWMFQZTaiGPDuw
- Weston, Liz. "Credit scores will plummet with a short sale." Los Angeles Times. April 10, 2011. (Oct. 16, 2013) http://articles.latimes.com/2011/apr/10/business/la-fi-montalk-20110410
- White, Martha C. "Want to Buy a Foreclosure? Here's What You Need to Know." Time. May 16, 2012. (Oct. 16, 2013) http://business.time.com/2012/05/16/want-to-buy-a-foreclosure-heres-what-you-need-to-know/