As missed monthly payments and mortgage defaults continue to rise, many homeowners are looking 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 anyways? 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.
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 mortgage crisis.
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 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. But if your existing mortgage balance is greater than the value of your property (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 be worth more than what they bought them for.
So a standard sale would be possible because these borrowers gained equity in their homes beyond the mortgage balance.
Once home prices began moving sideways or dropping, homeowners weren’t so lucky. That’s why many borrowers who got into negative amortization loans or even high loan-to-value loans found themselves with a mortgage balance that exceeded the value of their home.
Even if you put 20% down and made all your payments on time, you may have just purchased a home at exactly the wrong time, namely the height of the market, which eventually pushed your loan underwater.
Let’s look at an example where a short sale isn’t necessary:
2003 Property Value: $500,000
Existing mortgage balance: $490,000
2012 Property Value: $600,000
In the above situation, though very little of the mortgage has been paid off, 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, 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.
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, the borrower was making 1% 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 value of the home, making the situation ideal for a short sale if the borrower falls seriously behind on payments.
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 height 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 transactional costs involved. 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.
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 foreclosures. 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, a 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. And even if your situation fits, the bank or lender must still decide if your particular situation works for them financially.
As the ailing homeowner, you’ll need to find a prospective buyer for your home. And as you already probably know, selling a home takes time. 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
Though short sales can be a blessing to some homeowners, as they don’t do nearly as much credit score damage as a foreclosure (assuming you do them right), they should still be treated as a final option before foreclosure. Do you really want to lose your home and experience difficulty buying another one in the future?
There are other options out there to stop loan foreclosure, such as a short refinance or a loan modification, and if you speak with the bank or lender servicing your loan, they’ll likely point out other alternatives first.
Ultimately, banks and 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
One final note. 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 momentarily.
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. This can be 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.
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 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 buying process to be quite time-consuming, perhaps taking several months to be completed.
Remember, the bank needs to agree to the sales price, and banks don’t seem to be as prompt 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 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 that has already been agreed upon, 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.