Mortgage 101

What Are Short Sales and How Do They Work?

Published on: March 7, 2022

what are short sales

You may have heard the term “short sale” in real estate and wonder what are short sales and what’s involved. In a short sale, the owners sell a home for less than they owe on the mortgage. A short sale allows them to avoid foreclosure and have more control over their financial situation, but the lender has to agree to the transaction because they’re taking a financial loss. 

If you’re considering buying a short sale property, this article outlines the process and examines some of the possible pitfalls to watch out for.

What is a short sale?

It’s important to understand what a short sale is in real estate because the situation affects what the sellers, their lender, and the buyers do. A short sale occurs when the home is sold for less than what a seller owes on their mortgage. 

Sellers must get approval from their lender to short-sell the property, because the lender may take a loss. In some cases, the lender may accept the proceeds of the house and forgive the rest of the outstanding balance. In some states, the lender can require the seller the pay the difference through a deficiency judgment from a court. 

Buyers may want to buy a home via short sale because they might be able to purchase it for less than market value. However, the lender wants to recoup as much money as possible from the deal, so short sales can be time-consuming and complex.

How does a short sale work?

Real estate short sales are most common when home values decline rapidly. 

For example, someone may have taken out a $250,000 mortgage for a house, but as local home prices fell, the home’s value dropped to $230,000. Now the owners are “underwater,” owing $20,000 more than the home is worth. If they cannot afford the mortgage payments due to a financial hardship, they may ask the lender to accept a short sale to avoid foreclosure. 

From the seller’s perspective, the process of a short sale includes several steps. 

  • The lender must agree to the sale. The seller may still be responsible for the difference between the proceeds of the sale and the total amount owed. The difference is called the deficiency. 
  • The owners must prove to the lender that they can’t make regular monthly mortgage payments. They’ll have to submit documentation showing a financial hardship, such as a job loss or other disruption in income. 
  • Lenders will look at the total amount owed. In addition to the mortgage, there may be liens on the property, a second mortgage, and costs associated with selling the home. The lender will evaluate the sum of these costs to see if a short sale is a better option for them than a foreclosure. 
  • Owners must prove the home’s fair market value. A real estate professional or appraiser can provide a written estimate of the home’s value to show it’s less than what’s owed on the mortgage.  
  • Once the lender allows a short sale, the sellers must find a buyer, agree to a contract, and get the lender to approve the deal.

Short sale vs. foreclosure

Short sales and foreclosures both occur when someone cannot make their monthly mortgage payments, usually because of a loss of income or other financial issue. However, these transactions are not the same. 

  • In a short sale, the owners sell the home for less than they owe on the mortgage, and the lender gets all the money. The lender may agree to accept the proceeds to pay off the loan and cancel the remaining loan balance, or the seller may be required to pay the difference back through a deficiency judgment. 
  • In a foreclosure, the lender takes the property back from the borrower after the mortgage goes into default for nonpayment. The lender then sells the home to recoup their losses. 

In both cases, the owners lose their home because they couldn’t pay the mortgage. However, with a short sale, owners have more control over the process and when they must leave their home.  

Both events will damage the owners’ credit, but a foreclosure tends to do more harm than a short sale. Research by FICO, which produces the credit scoring system many lenders use, finds the impact of a short sale or foreclosure varies depending on the consumer’s starting FICO score. Consumers with higher starting scores took a bigger hit to their credit, and it took longer for their credit to recover after a short sale than it did for someone with a lower starting credit score.  

  Short sale  Foreclosure 
Who decides on process  Owner asks for lender approval  Lender starts process 
When owner leaves house  After sale  Varies, but typically after foreclosure sale 
Effect on credit  May be significant  Significant 

Process of buying a short sale home

Buying a short sale home can be complicated because you must deal with the seller and the seller’s lender. If other creditors have a lien on the property, they may also get a say in the transaction. Be prepared for your offer to be turned down or to have multiple hoops to jump through. 

As a buyer, hire an experienced real estate agent with experience in short sales. The National Association of Realtors offers a Short Sales and Foreclosure Resource certification, or SFR, that prepares agents to help buyers and sellers involved in a short sale.  

Remember that homes in a short sale are usually sold as-is. Since the sellers couldn’t cover the mortgage payments, it’s unlikely they’ll have money to put into repairs and upgrades. 

Steps to buying a short sale home 

Get preapproved for a loan. We recommend this whenever you’re shopping for a home, but preapproval is generally required for a short sale. You’ll have to include your preapproval letter in the short sale package. 

Get the home inspected. Having a home inspection contingency in your offer is key to avoid being on the hook if a home inspection reveals major issues. This contingency gives you an exit from the transaction without financial penalty.  

Find out who has a claim to the property. Multiple liens on the property can complicate the sale. The best way to find all the liens is to pay for a title search, which your lender will require anyway if you finance the purchase. 

Determine the market value of the home. Your real estate agent can help by finding comparable sales. Remember, the lender wants as much money as possible from the property; lowballing the offer because it’s a short sale may result in your offer being rejected, especially in a competitive seller’s market. 

Be prepared to wait. Getting approval from the seller’s mortgage company could take months. If you have a more urgent timeline to stick to, a short sale may not be ideal for your situation

Where to find short sale properties

Buying short sale properties brings risks you don’t encounter with a typical home sale. It’s important to work with a real estate agent who understands the intricacies of buying a short sale. 

Another advantage to working with an agent who specializes in short sales is that the agent can help you find properties that are offered in a short sale. Additionally, you may be able to find short sale properties by typing “short sale” in as search criteria on home listing websites. 

Looking to get preapproved before you start your home search? Talk to a local Finance of America Mortgage Advisor today to learn more about your options.

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