When your home value sinks below the amount you owe on your mortgage and you need to sell the house as soon as possible because you can't keep up with payments, a short sale might be your best option.
Short sales are categorized as a distressed sale for a reason -- they are often a last-resort option to avoid a foreclosure. You have to convince your lender to accept a short sale, because it will cost the lender money, and if it goes through, your credit history will have a negative mark, which will hurt your credit score.
Fortunately, short sales are much less common now than they were during the housing crisis in 2008. Here is a guide for both sellers and buyers on how to navigate and make the most of a short sale.
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What Is a Short Sale?
A short sale occurs when a lender agrees to let you sell your home for less than what you owe on your mortgage. In this scenario, a homeowner is "underwater." In today's real estate market of rising home prices, it's unusual for homeowners to be underwater on their mortgages. According to the ATTOM U.S. Home Equity and Underwater report, just 1 in 29 homes (or 3.4%) were "seriously underwater" in the third quarter of 2021, where property owners owned at least 25% more than the estimated market value of the property.
Being underwater isn't enough to trigger a short sale -- you also need to be forced to sell the home for some reason. Maybe you changed jobs suddenly and need to move right away, or maybe you've fallen behind on payments because of a divorce, job loss or severe debt issues.
"You're selling your home because of financial distress," says Frank Jacovini, associate broker at ReMax Central in Philadelphia. "The market value for the home is less than what is owed on the mortgage. In that situation, you appeal to your lender to accept a short sale, basically accepting less than what is owed on the property."
Although short sales are not ideal for either the lender or homeowner, they might be the best option for both -- and certainly preferable to a foreclosure. A bank could spend more money on legal costs for a foreclosure than what it loses on a short sale, and homeowners could cause more damage to their credit with a foreclosure than a short sale.
"If a loan modification is not an option for the seller, the next best option is a short sale, if the lender agrees to it," says Jay Plum, head of mortgage for Fifth Third Bank. "There are situations where a seller must move far away for employment, the borrower is overextended financially due to a divorce, death of a primary borrower or income is reduced due to a disability. In these cases, you should contact your lender and be evaluated for a short sale. A short sale is a much better option than foreclosure."
In most cases, a lender will not require the homeowner to cover the unpaid amount of the mortgage balance, Plum says.
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How Can You Avoid a Short Sale?
If you are in financial distress and your home's value is below the amount of your mortgage, contact your lender right away, as you might have options other than a short sale.
Here are some of them:
-- Loan modification. "A loan modification is a solid solution for sellers wanting to keep their home," Plum says. "Modification programs are designed to lower the monthly obligation to make the mortgage payment more affordable. Homeowners should contact their lender when they face mortgage challenges to determine which workout option best suits their unique financial situation."
-- Forbearance/repayment. A lender might allow you to pause your mortgage payments for a period of time because of your difficult financial situation. This is an option that has been offered during the coronavirus pandemic and could occur in other situations in the future. Realize that you will need to set up a repayment plan with the lender once the forbearance period is over.
-- Deed in lieu of foreclosure. If you are not able to get a short sale, you can transfer ownership of your property to the loan servicer to avoid a foreclosure sale. This should cover all or most of the mortgage debt.
For Sellers: Steps in the Short Sale Process
There are two paths you can take to a short sale -- get prior approval from a loan servicer after you provide documentation detailing your financial distress, or list the home and get an offer, then ask if a short sale could be an option.
Here are the typical steps in a short sale:
-- Hire a professional. Before you try to sell, you'll want to enlist the help of a real estate agent and possibly an attorney. "You're going to need guidance through the selling process and maybe a little help with coordinating things with the lender," Jacovini says. "You need a professional's assistance."
-- Get the best deal you can. It's possible that you might get more than you expected for the home, which could help you prevent a short sale.
-- Provide a proposal. The lender that issued your primary mortgage will review your proposal, which will include the prospective buyer's offer, housing market information that puts the offer in perspective, and proof that you've had all other liens released (such as a home equity line). You also might need to provide documentation on your financial situation.
-- Wait. Short sales generally take longer than conventional home sales because a bank or loan servicer might need to get multiple internal approvals, hire an appraiser and make a counteroffer to the prospective buyer.
-- Close. Before the home closes, try to get a waiver from the lender to ensure you're not responsible for the amount of the loan that isn't covered by the sale. There might be tax implications if any of the mortgage debt is forgiven. Also, watch your credit record and score, as each will likely be affected by the sale.
For Sellers: Short Sale Pros and Cons
-- Limit credit damage. A short sale could be a hit on your credit record because you sold the home for less than it was worth, but you might limit the damage if you were up to date on your payments before the sale. A foreclosure often involves a series of missed payments and stays on your credit report for seven years after the first payment you skipped that started the process.
-- Get a quicker resolution. Foreclosure involves a court action by the lender because it needs to forcibly take the mortgage due to nonpayment, and it could take years depending on state laws. A short sale likely takes a few months, depending on approvals. "The sellers can avoid the foreclosure process, avoid additional legal fees, and forgo having an actual foreclosure showing on their credit bureau report," Plum says.
-- Long, sometimes difficult process. Lender approvals can drag out the process, and buyers might walk away from the offer. A lender could also decide to turn down the short sale and proceed with foreclosure. "The lender has the ultimate authority on whether the sale is approved or not," Jacovini says.
-- Financial hit. Not only would you walk away from the sale with no proceeds to help you put a down payment on another home, but you'll also have a declining credit score, which hurts your ability to get the lowest available interest rates on loans.
For Buyers: Steps in the Short Sales Process
If you want to buy a home on a short sale, you'll have to look harder now than in past years because home values have risen and fewer homes are underwater.
A 2021 report by ATTOM showed that distressed home sales -- which include foreclosures and short sales -- totaled 7.8% of all U.S. condo and single-family home sales in 2020, the lowest amount since 2005. That is in stark contrast to 2011, when 38.6% of home sales were distressed.
Here are some ways to get started and secure a short sale property:
-- Get preapproved. It's important to get at least one lender to preapprove you for a mortgage and verify that you can get a mortgage based on your credit score and potential debt-to-income ratio.
-- Hire a professional. A buyer's agent who is experienced with the short sale process is a valuable ally to help you navigate the potential complications and negotiate with the multiple parties involved.
-- Look for a home. Your agent should lead this effort, and you could also find homes online that are identified as short sale properties. You might want to check local courthouse records, which might reveal the need for a short sale.
-- Do your due diligence. Make sure to schedule inspections -- such as a general home inspection, radon and others -- once your agent assures you that the process is moving forward.
-- Be patient. If you need a home as soon as possible, a short sale likely isn't the best option because it will take up to four months. This is considerably longer than a typical sales process, which usually wraps up in 45 days to meet the deadline on the purchase contract.
"The buyer should follow the same steps they would with a traditional home purchase," Plum says. "Before making an offer, they should determine what they can afford, talk to a mortgage loan specialist and get prequalified for a loan."
For Buyers: Short Sale Pros and Cons
-- Patience can pay off. You will likely have less initial competition to buy a short sale home, and could outlast other buyers if you take a long-term view and stay in the bidding game for as long as possible.
-- Save money. Your home investment is more likely to pay off in the long run if you purchase a home for less than its value. You also might have more cash on hand to make needed repairs and upgrades on the property.
-- Long wait. You might not be able to hold off on buying a house for a few months or more while the short sale is considered.
-- Complicated process. Deals can fall through for a variety of reasons, especially since the lender and seller might not agree on the bid or process.
"You might get a good deal, but a lot of times you get burned," Jacovini says. "The waiting process for a short sale could be lengthy."