In a time when foreclosures are looming over the real estate market, underwater homeowners who have staved off foreclosure might find a short sale to be increasingly tempting.
When a property owner begins defaulting on mortgage payments and the property’s value falls to less than the amount owed, many homeowners believe foreclosure to be imminent. A smaller number of homeowners consider a short sale because they want to stay in their homes for as long as possible.
A short sale, in terms of real estate, is the sale of a property for less than the mortgage balance owed by the homeowner. Both the homeowner and lender must agree to sell the property in a short sale. Even after completing a short sale, the owner is still responsible for the remaining balance (also known as the deficiency balance), but that remaining debt can be forgiven as part of an agreement with the lender.
The Lender Decides
A short sale is often a better option than continued non-payment or a foreclosure, which will eventually end up costing the lender more money. After filing the paperwork to repossess the property, lenders would be responsible for marketing and selling the foreclosed home. So they’d rather agree to a short sale in which they would suffer a smaller loss and allow the homeowner to deal with selling the home.
Lenders have their own criteria for justifying a short sale. Eligibility for short sales is largely based on financial hardship and the mutually agreed-upon sale price. If a homeowner cannot prove significant financial distress to the point where future mortgage payments are highly unlikely, most lenders will not consider a short sale.
Also, a short sale is less likely to be approved if the home has a second mortgage with a separate lender because that would mean an additional party must agree to sustain possible losses on the balance that it is owed.
In the end, the lender is trying to work with the distressed homeowner to minimize its losses.
Pros of a Short Sale
- Troubled homeowners can get rid of costly mortgages on undervalued homes and start rebuilding their finances.
- The negative effect on credit scores may be equivalent to that of a foreclosure but a small benefit may come from the debt relief when the lender offers to forgive some or part of the outstanding debt after a short sale.
- There are many accounts of it being easier to obtain a new mortgage after a short sale because it is considered a regular home sale, not a foreclosure sale.
- Typically, a short sale is a faster, and less costly, process than foreclosure for both the homeowner and lender.
Cons of a Short Sale
- Homeowners are at the mercy of lenders because both parties must consent to a short sale. Even after agreeing to a short sale, lenders may back out of the agreement at any time for their own reasons.
- A short sale will only settle a portion of the mortgage balance owed to the lender. The lender still has the right to pursue the outstanding deficiency balance unless it agreed to waive this right when negotiating the specifics of the short sale. There may be taxes on the forgiven debt, which is considered income.
- While the process of a short sale is usually quicker than that of a foreclosure, a property that is difficult to sell may end up costing both parties (which is one reason why lenders may revoke the short sale agreement).
Is a Short Sale Always Better Than Foreclosure?
Generally, a short sale is the better option.
It is easier to wave the white flag and wait for lenders to foreclose on a home but it isn’t the wisest approach if underwater homeowners want to do their best to salvage their finances. The pros outweigh the cons. In any case, homeowners can try to qualify for a short sale before letting their property go into foreclosure.
Simon Zhen is a research analyst for MyBankTracker. He is an expert on consumer banking products, bank innovations, and financial technology.
Simon has contributed and/or been quoted in major publications and outlets including Consumer Reports, American Banker, Yahoo Finance, U.S. News – World Report, The Huffington Post, Business Insider, Lifehacker, and AOL.com.