What is a short sale?

A short sale refers to a transaction where the proceeds from the sale of a property, is less than the debts secured by liens against that property. These liens generally include a first mortgage used to finance the purchase of the property and may also comprise of other liens such as judgement liens or overdue Homeowners Association fees.

In real estate, a short sale normally arises when the home owner’s debt on their property (total of liens and mortgages) fall “short” of the current market value of the property. In this situation, the owner is considered to be “underwater”. Also, the owner needs to obtain a “marketable title” (a compulsory requirement for lending institutions offering purchase loans to new buyers) to proceed with the transaction. However, any liens on the property must be released before transfer of such a title. The homeowner must acquire permission from the mortgage lender before the sale, unless they can generate the required cash to pay the balance owed in the mortgage. A short sale may also become necessary when the underwater borrower/homeowner lacks the requisite equity to pay off the closing costs of sale.

For example, if you as a borrower, owe a debt of $200,000 on your mortgage and receive a purchase offer worth $210,000, you will still require your lender’s approval to proceed with the short sale. This is because the transaction would also include various closing costs on sale (legal fees, agent’s commissions, outstanding tax bills, etc.), approximately around $25,000. So, the purchase offer you have received ($210,000) is not sufficient to pay off the mortgage ($200,000) including the closing costs. Your net proceeds to the lender, after deducting the closing costs will be $185,000, which still falls $15,000 short of the owed balance.

Difference between Short sale and Pre-foreclosure sale

The terms short sale and pre-foreclosure are basically two sides of the same coin. Pre-foreclosure sale belongs to a specific class of short sale, where the borrower has failed to pay off the mortgage and is facing foreclosure. However, in a short sale, a borrower may or may not be delinquent, and the lender settles for a payoff that is less than the balance owed on the mortgage. In general, pre-foreclosure sale is used mainly with respect to FHA loans.

A short sale that is not a pre-disclosure sale, may also take place when a borrower realizes that they will become delinquent if they fail to sell off their home. A short sale can also be used as a preventive measure. For example, consider a situation where you, as a homeowner is facing reduced income due to decreased work hours. So, you will need to initiate a short sale, or face foreclosure.

Financial Distress: Utilizing Short sale to avoid foreclosure

An underwater mortgage does not necessarily initiate a short sale. If you have sufficient income to continue making the payments, you can wait for an anticipated price increase and keep the underwater mortgage. However, if you are not confident enough about any such increase, and fail to take any action, you will face foreclosure.

There are ample examples of people underwater with their mortgage, struggling to make the payments due to financial distress arising from unemployment, increased cost of living, wage cuts or unexpected debts. All these people are waiting for the economy to improve as they face foreclosure. They can opt for short sale and avoid the distress and stigma that accompanies a foreclosure.

Strategic Default

When a homeowner fails to accumulate enough income to pay-off their monthly bills, they become delinquent on their mortgage payments. However, some owners may actually choose to default on their mortgages. This is known as “strategic default”.

Strategic default involves the lender into the situation, providing them with ample incentive by creating an artificial situation. The moment a borrower defaults, they become “non-performing loans” to the lenders. Suddenly, the lender faces a situation where, instead of acquiring interests on the loan, they have to figure out how to decrease their losses. They have 2 options, foreclosing the borrower or suffering a calculated loss by approving short sale. And more and more lenders are choosing short sale in such situations. So, a strategic default may arise when a non-delinquent borrower can convince the lender that they are “at imminent risk of default”.

Privacy policy: Short sale

During Short sale, you have to disclose your financial information as a show of good faith. However, there is no need to be nervous, as not “all” of your private information is disclosed. In a short sale, the lender is settling for a loss, so they will require the borrower’s financial information to decide whether they want to proceed with the transaction.

Why would a lender approve a short sale, and settle for less than they owe?

A lender’s primary goal is to either make money or settle for a controlled loss. In case of a non-performing mortgage, the lender’s aim is solely focused on losing as little as possible. This is known as “loss mitigation” or minimizing loss. Short sales are becoming increasingly popular at the moment, with more and more homeowners opting for it to avoid foreclosure.

The lender is in the business of making money. And in every such business, the sole aim is to either gain revenue or in case of detrimental situations, minimize any expected loss. Banks will settle for a short sale under the following circumstances:

Seller provides documented evidence of hardship

If the seller is suffering from financial hardship due to circumstances beyond their control and applies for approval of short sale, banks tend to settle for the same in most cases. However, don't expect to just walk away with it if you own assets or any sort of disposable income. You will have to provide documented evidence of such instances.

Seller has received a reasonably priced offer from a qualified buyer

The sales price quoted should be close to the comparable expected market price. Sometimes, the bank may counter an offer just to see whether the buyer is willing to pay more. However, the buyer's lender still needs to evaluate the price agreed upon. Before such approval, the bank may demand to see a pre-approval letter, or in a case, if the buyer has acquired investment, proof of any such funds. The short sale transaction must make sense to the bank. Simply the declining value of a house is not a valid enough reason to approve a short sale.

When you are facing foreclosure, either you will have to sell it at Fair Market Value (or below) or the bank will acquire the property and make the sale themselves. It’s a known fact that, at best, the bank may only get to sell it at fair market value. So, getting full repayment on the debt is near to impossible. That’s why the bank would rather approve the short sale at fair market value. Also, they get to avoid any expenditure relating to attorney fees associated with foreclosing.

Why choose a short sale, even when it’s not profitable?

Let's check out the reasons:

If you choose short sale over foreclosure, you can preserve your credit rating. Foreclosure generally costs 200 to 300 points, when compared to short sales, which cost a mere 50 to 100 points.
If you stop investing in a sinking ship, it will aid your long-term financial stability. Even if you face foreclosure, a short sale can be the perfect strategy to unburden such debts. It’s about minimizing the damage.
Preserve your dignity, to avoid the stigma of facing foreclosure. Having your home repossessed or sharing the fact that you failed to pay your debts with your family and friends is never a good feeling.

A short sale represents a dignified measure from a bad mortgage. It represents a transaction where both the homeowner and lender can reach an outcome, that is negotiated and agreed upon by both parties.