A Realtor called me the other day and described the following scenario. Her client had purchased a town home in the spring of 2005. The client paid a purchase price of $355,000.00. While he was short of cash, the client had a good salary and was able to qualify for 100% financing. Shortly after the client had gone to settlement on the purchase of the property, his company downsized, and the client lost his job. The client was forced to accept a job with another company with a significantly reduced income. Concurrently, the client’s expenses increased because of an impending divorce, making it impossible for him to afford his monthly payments on the loan. Facing the possibility of foreclosure, the client had no choice but to list his property for sale. Unfortunately, in the two years since the client purchased the property, the bottom had fallen out of the real estate market. As a result, while the client’s loan balance is about $355,000.00, the market value of his home is in the range of $310,000.00. Factoring in costs and expenses of sale, the client would need to bring about $70,000.00 to the table to complete settlement. Since the client had very little cash, the agent wanted to know if there were any alternatives available for the client.
Lenders in today’s market are seeing this situation with increasing frequency, and are suffering tremendous losses due to borrowers’ defaults on home loans. As a result, many lenders are searching for methods to avoid mounting losses incurred in foreclosing on properties. One of the principal alternatives to foreclosure is called a “short sale.”
A short sale is a negotiation between the homeowners and their lender to reduce the amount necessary to pay off the loan (s) on the property at the time of settlement. The hope is that the lender will get the majority of the loan balance paid, and the homeowners will not have to bring money to the table to settle on the sale of their residence. The lender will forgive the shortfall and allow the sellers to move on with their lives.
You may wonder how a short sale could possibly help the lender save money. The lender benefits by allowing the seller to sell the house directly to a third party, thereby avoiding the expense and delay of a foreclosure action. Typically, after all costs and expenses of a foreclosure are paid, the lender nets about 60-70 percent of the loan balance. Moreover, if the lender is forced to buy back the property in foreclosure, the lender will have to pay the costs of the foreclosure action, the carrying costs of the property, the cost of fix-up/repair, and finally, the costs involved with re-listing and reselling the property. This scenario exposes the lender to even further losses.
From a homeowner’s standpoint, a short sale may be very advantageous. Foremost, the owner of the property (the seller) usually avoids having to bring money to the settlement table in order to sell the property. In addition, a successful short sale usually results in a rather benign credit report entry, at least as it compares to two of the most feared credit report entries- foreclosure or bankruptcy. Finally, the homeowner may avoid having to “pay back” some missed monthly mortgage payments.
There are, however, several disadvantages for the seller. First, there are some lenders who may require the homeowner/seller to sign a Note promising to repay the Bank a portion of the loan deficiency. Moreover, if the lender does reduce the payoff balance and forgives some debt, this may result in a taxable gain for the amount of debt forgiven on the loan. Finally, the short sale process can be a long and arduous journey, requiring the homeowner/seller to fully disclose their entire financial condition. Also, any contract for sale will have to be contingent on Lender approval of the short sale. This may scare away some buyers.
Before getting involved in such a transaction, the real estate agent must decide early in the process if there is enough of a chance of a successful short sale to justify the time and expense of taking the listing. To judge this, the agent will need to ascertain certain essential facts. First, in order to approve a short sale, a lender will require that the seller is under a significant hardship. Lenders typically require such things as a divorce, death or medical disability or loss of job or income. The agent must also know how many loans and other liens exist against the property. The more liens on the property, the less likely that the short sale will succeed. In addition, the agent must determine whether the Seller will be willing to put in the time and effort to complete the short sale application, which consists of a hardship letter, 2 years tax returns and W-2s, up to 6 months worth of bank statements and pay stubs. Finally, the time for completing a short sale can be 45-60 days. If the parties involved don’t have that kind of time available, it may not be prudent to pursue a short sale.
Short sales can indeed be a better alternative than foreclosure or bankruptcy. However, all parties should be aware of the various risks involved with the transaction.