When the mortgage crisis struck, missed monthly payments and mortgage defaults increased dramatically, forcing many homeowners to look for a way out, hoping to avoid foreclosure along the way. One such way is via a “short sale.”
So what is a short sale anyway? Well, in short, it’s a carefully agreed upon sale of a property for less than the amount of the mortgage balance, executed as a means for both a homeowner and a mortgage lender to essentially cut their losses if a traditional sale is not possible.
Put simply, if what you owe on your mortgage exceeds the current value of your property, you could be a short sale candidate if you wish to leave your home.
Short Sales Have Become Increasingly Common
Although not normally a common practice, short sales have surged in popularity as a result of the most recent housing downturn, which was the perfect storm of inflated home values and exotic financing, the latter of which was designed to make a home affordable at the time.
Typically, short sales are reserved for extreme cases when the bank or lender decides that it is in their best interest to take an early loss instead of enduring costly foreclosure proceedings. Yes, foreclosures cost banks and mortgage lenders money too.
If you’ve missed a few mortgage payments and recently received an NOD, or Notice of Default, you may be seeking out foreclosure alternatives. Even if you’re still making on-time payments, you might want to sell and on move on for whatever reason.
But if your existing mortgage balance is greater than the value of your property (referred to as an underwater mortgage), and you don’t have the ability to make your mortgage payments in full, you could have few places to turn aside from foreclosure.
The reason foreclosures weren’t a problem in preceding years was due to appreciating home prices and more prudent financing options. Even if homeowners fell behind on payments, their homes would often be worth more than what they bought them for.
So a standard sale would be possible because these borrowers had equity in their homes beyond the outstanding mortgage balance.
Once home prices began moving sideways or dropping, some homeowners weren’t so lucky. This was especially true for borrowers who got into negative amortization loans or even high loan-to-value loans, who found themselves with a mortgage balance that exceeded the value of their home.
Even those who put 20% down and made all their payments on time may have just purchased a home at exactly the wrong time, namely the height of the market, which eventually pushed their home underwater too.
Let’s look at an example where a short sale isn’t necessary:
2003 purchase price: $500,000
Existing mortgage balance: $490,000
2012 property value: $600,000
In the above situation, even though the outstanding mortgage balance is just below the original purchase price, there is still $110,000 in home equity, so a short sale is not necessary, as the owner could sell the home and cover the cost of the mortgage and closing costs with plenty of room to spare.
The homeowner in this example may have pulled cash out or opened a home equity line of credit after home prices increased, but because they didn’t fully tap out their equity, they’ve still got breathing room to avoid a short sale if they’re unable to continue making payments.
If we consider that listing agents take 3% of the sales price and give another 3% to the buyer’s agent, then we add another 2% in transaction fees, that’s only $48,000. The home seller could still walk away with roughly $62,000.
Here’s an example of when a short sale may make sense:
2006 property value: $650,000
Existing mortgage balance: $675,000
2012 property value: $655,000
In this example, though the home appreciated ever so slightly over six years, the borrower was making 1% minimum payments each month via an option arm, thus tacking additional interest on top of the existing loan balance.
The result is a mortgage balance greater than the current value of the home, making the situation ideal for a short sale if the borrower falls seriously behind on payments, or simply wants to walk away.
Of course, even those who made fully-amortized mortgage payments each month have found themselves upside down on their mortgages thanks to the precipitous drop in home prices over the past few years. This was mainly due to the zero down mortgages that were popular just at the peak of the housing boom.
Clearly this was a deadly combination for even the most responsible of homeowners, which explains why short sales and foreclosures have become so prevalent.
Note that even those with some equity might not be able to sell their homes because of the transaction costs involved.
As illustrated above, if you use a real estate agent you’re looking at 5-6% of the purchase price. Factor in transfer taxes and other closing costs and you might have to pursue a short sale, even if the amount owed is less than the home’s value.
Short Sales Are Complicated and Time Consuming
So are short sales the answer? Before you think you’ve got the magic bullet, think again. Short sales are complicated, just like the foreclosure process, and require lender approval.
They take a lot of time and work, as well as cooperation from a number of interested parties, including the bank or lender, loan servicer, investor on the loan, home buyer, real estate agents, and you.
If you’ve missed multiple mortgage payments and are facing foreclosure, the bank or lender won’t automatically offer a short sale. You need to prove that your situation merits a short sale, which typically involves providing documentation that proves you are indeed in dire straits (not the band) with no other viable options.
Even if your situation fits, the bank or lender must still decide if your particular situation works for them financially. They aren’t offering this option out of the kindness of their heart. So it can be a fight and take a lot of time to get a short sale approved.
And as the ailing homeowner, you’ll still need to find a prospective buyer for your home. As you probably already know, selling a home takes time, even if it’s a short sale property. In fact, it can take even more time than a traditional sale because both the bank and the buyer have to agree on the sales price.
This will also make the home buying process more cumbersome, and could lead to a lot of fallout if a first-time home buyer gets spooked or impatient.
Couple that with the complicated process of assessing comparable sales in the area and the fact that the lender must decide if the price is right, and you’ll quickly realize that things could take a while.
Short Sales Are a Last Resort
Ultimately, there are pros and cons to short sales, like anything else.
Though short sales can be a blessing to some homeowners, as they may not do as much credit score damage as a foreclosure (assuming you do them right), they should still be treated as a serious and final option before foreclosure.
After all, do you really want to lose your home and experience difficulty buying another one in the future? Sure, the short sale will result in a shorter waiting period to buy a home again, but it’s a wait nonetheless.
Freddie Mac and Fannie Mae require at least a two-year wait, possibly four years without extenuating circumstances, compared to three or seven years for a foreclosure.
Another plus to a short sale is that you might be able to avoid a deficiency judgment, where the lender can come after you for the shortfall between the sales price and loan balance. But tax implications may still persist.
There are other loss mitigation options out there to stop loan foreclosure, such as a short refinance or a loan modification program, and if you speak with the bank or lender servicing your loan, they’ll likely point out other alternatives first.
Ultimately, banks and mortgage lenders want to cut their losses, and they’ll do whatever is in their financial interest, first and foremost.
So if you do decide to pursue a short sale, you’ll need to make a strong case for yourself or you’ll likely be denied. Though the volume of short sales picked up quite a bit post-crisis, it won’t always be an option.
Make sure you consider all of your alternatives before making the huge decision to sell your home.
Those Who Stuck Around Are Now in Good Shape
Many of those who were able to endure the housing crisis and hold onto their homes are actually in great shape nowadays.
I know folks who were underwater by more than a $100,000 during the dark times a few years ago, but are now up several hundred thousand dollars from the time they purchased the property.
Often, if you’re able to ride out a bad cycle in real estate, you can come out way ahead, even if you’ve got a huge paper loss on your hands temporarily.
And that’s the takeaway. It’s not actually a loss until you decide to part with the property for less than what you bought it for.
Of course, many couldn’t afford their homes, or were unwilling to keep paying large mortgage payments because they didn’t believe home prices would rebound. With the benefit of hindsight, we now know this may have been a huge mistake.
Imagine selling Apple stock back in 2009 because you got spooked, only to watch it rise tenfold five short years later.
The same concept can be applied to a home, granted you have to continue paying a mortgage to reside in it each month. The point is that real estate isn’t a short term investment, nor is it something you should take lightly.
Always make sure you can afford to stay in the home through good times and bad, and pay close attention to the type of financing you use to purchase your property to ensure you can afford it regardless of what happens.
Hopefully you won’t find yourself in a situation where you need to sell your home short, but it can be a useful solution for some who no longer have the means to keep their property.
Buying a Short Sale for a Discount
If you find yourself on the other side of the fence, as the prospective buyer, a short sale purchase can be a great deal.
You’re essentially getting a discount on a home that the existing owner can no longer afford. And it may be in perfectly good shape, in a desirable part of town, unlike a foreclosure, which may need considerable work.
However, as noted, expect the short sale process to be quite time-consuming, perhaps taking several months for the short sale transaction to be completed.
Remember, the mortgage company needs to agree to let the borrower sell short and establish an acceptable sales price, and banks don’t seem to be as motivated as homeowners might be.
The trade-off is that you should be able to get a lower than market value price for the home. While short sale discounts will vary by city, state, and time period, you could save anywhere from five percent to 20% or more.
One of the quickest and easiest ways to buy a short sale is to make an offer on a property that already has bank approval for a certain sales price.
If the lender has already agreed to accept the listed price, a sale can move rather quickly, potentially as fast as a traditional sale.
For example, if a buyer backs out after successfully negotiating a short sale price, you can move in and make an offer without delay. In this case, you might be able to close in as little as 30 days and ideally save some big bucks.
Read more: Short sale waiting periods.