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How does a short sale work for the buyer?

House with a short sale signYou may have heard the term “short sale”, but what does it mean? The term short sale is the real estate language for a home that is offered for sale at a discounted price below the mortgage balance. In most situations, the homeowner is facing foreclosure and the lender agrees to allow the seller to fall "short" of the mortgage balance.

In many short sales, the seller has either defaulted on the loan or is close to foreclosure. Short sale contracts may not completely discharge the seller from their mortgage obligation, unless specifically agreed to by the seller.

After finding a prospective home buyer, the homeowner or real estate agent will present the lender with the buyer's offer. In some cases, an appraisal or market analysis accompanies the buyer's offer to the lender. The lender will ask for a pre-approval letter from the buyer (see below). The approval of the contract is up to the lender, not the homeowner. Most real estate agents who have experience with short sales will tell you that lenders do not move fast after they receive a short sale offer, so be prepared to wait until someone at the bank or mortgage company responds to your offer. In fact, you may wait months for your offer to be approved or rejected by the bank. Short sales are best for buyers who can wait.

The Risk of buying a short sale

The home will be sold "as is." The home buyer will be responsible for any repairs that may be required by their lender (i.e. roof, foundation, retaining wall, etc.); and it is possible to make the repairs for your mortgage company, only to have the sale fall apart at the last minute for one reason or another.

You will pay all closing costs when you buy a short sale. Banks are likely to refuse to pay fees that are customarily split with the seller, such as deed transfer, mortgage, or excise stamps

If the home is vacant and the utilities have been disconnected, the lender is unlikely to have the utilities turned on for a home inspection.

An earnest money deposit will accompany the offer, and if the sale drags on and you want to purchase another house, the release of your deposit may take sometime.

Sellers can be uncooperative and slow to submit paperwork required by their lender, this may stall the review process.

Some banks/mortgage companies require home sellers to make a payment at settlement, called a “contribution”, to help reduce the lender's losses. Some sellers wait until the last minute and then refuse to pay the contribution fee or think that the buyer will pay it for them. When this happens, the short sale is not approved and will not close.

Other drawbacks to a short sale include:

  • the seller canceling the short sale contract
  • a foreclosure action which prevents the short sale
  • the seller files for bankruptcy

Making an offer on a short sale

If you are interested in a short-sale property, choose a real estate agent who has dealt with short sales. Your real agent should do some research before making an offer. You need to know how much the homeowner owes on the property and whether the homeowner has more than one loan. If there are multiple liens on the home, the approval of all lenders are required to make the sale, and the more lenders there are, the harder that will be to get approval of the short sale, because each lender must accept a smaller piece of the pie. Lenders reportedly favor offers of at least 85% of the property's appraised value, however in severely distressed real estate markets, lenders have been known to accept as little as 50% of the appraised value.

FHA short sale guidelines

Here are the guidelines for an FHA loan after a short sale. The FHA loan program only requires a 3.5% down payment and is the least difficult mortgage available. Learn more about FHA home loans

If a borrower surrenders a property through a short sale within three years after the case number assignment, they are usually ineligible for a new FHA-insured mortgage.

The lender must show that three years have passed since the short sale was completed.

The mortgage must be reduced to a refer and manually underwritten if the short sale occurs within three years of the case number assignment date.

This three-year term starts on the day of a short sale's transfer of title.

If the date of the short-sale transfer of title is not verified by the credit report, the lender must acquire the short-sale papers.

Exception for current borrowers at the time of the short sale

A borrower is deemed qualified for a new FHA-insured mortgage if, as of the date the new mortgage's case number is assigned:

For the 12-month period before the short sale, all mortgage payments on the previous mortgage were paid within the month due; and

Payments on installment debts for the same time period were likewise paid during the month that they were due.

Extenuating Circumstances Exception

If the short sale was the result of proven mitigating circumstances beyond the borrower's control, such as a severe sickness or the death of a wage earner, and the borrower has re-established excellent credit after the short sale, the lender may give an exemption from the three-year rule.

Divorce isn't seen as a mitigating factor.

If a borrower's mortgage was current at the time of the borrower's divorce, the ex-spouse acquired the property, and there was a later short-sale, an exemption may be allowed.

Extenuating circumstances do not include the inability to sell the property owing to a job transfer or move to another region.

If the short sale was caused by a situation beyond the borrower's control, the lender must seek an explanation and proof that the event was out of the borrower's control.

SOURCE: FHA underwriting manual, page 260

Conventional short sale (Fannie Mae)

A conventional home loan is a mortgage that is not backed by the Federal government (i.e. FHA, VA, and USDA). Read more about Conventional Loans

A typical home loan is one that satisfies the Federal National Mortgage Corporation (Fannie Mae) and the Federal Home Loan Mortgage Corporation's underwriting standards (Freddie Mac).

Fannie Mae mandates a four-year waiting time from the date of the deed-in-lieu of foreclosure, preforeclosure sale, or charge-off as recorded on the borrower's credit report or other papers.
A two-year waiting period is allowed if exceptional circumstances can be proven.

Foreclosures may take up to 7 years to become eligible for a conventional loan; however, exceptional circumstances can shorten the waiting period to 3 years, but only if a 10% down payment is made on a primary home.
SOURCE: Fannie Mae

Now for the downside of a short sale. Under a short-sale agreement, the lender may require the owner to sign a contract for the difference between the sales price and balance on the mortgage. Another complication with a short sale is a second loan balance (i.e. home equity loan, home equity line of credit), if any.

A short sale may require the homeowner to pay income tax on the loan amount that was forgiven under a short sale.

Conclusion

A short sale is more forgiving on a credit report than a foreclosure and purchasing another home can occur sooner than with a foreclosure, however, before you approach a lender about a short sale, speak to an attorney who can advise you regarding any continued obligation under the first mortgage and any deficiency judgment on the part of any second mortgage. And any tax liability must also be considered!

Rotating question markFrequently Asked Questions About Short Sales

Q. Are short sales a good deal?
A. A short sale can be a good deal, if the price is right. But be prepared to wait for the bank to respond to your offer. Now you would think that the lender would want to come to an agreement with you, take a loss and move on. But that doesn't happen. Most agents make a heavy sigh when you bring up short sales, because he or she knows that banks take their time before they even look at your offer; and after stringing you and the agent along, you will give up and maybe lose a better house during the waiting period.

Q. Can short sales be financed?
A. Short sales can be financed provided the house meets the standard appraisal guidelines. Is the house vacant? If so, you might be responsible for the utilities to be turned on. The appraiser will want to make sure that the plumbing is working properly, along with the furnace, and air conditioner.

Q. Does short sale mean cash only?
A. The lender who holds the loan against the house doesn't care whether you bring a check to closing or is paid off by another lender who finances the house. A short sale just means the current lender will receive less than the mortgage balance.

Q. What is the difference between a short sale or foreclosure?
A. A short sale is an agreement between the property owner and the lender that allows the lender to sell the property for less than the mortgage balance. If the homeowner obtains a purchase agreement, the sales contract must be approved by the mortgage company before the owner can sign the sales contract.

Q. Which is better a short sale or foreclosure?
A. Short sales can seem awfully attractive to the homeowner. First, the homeowner can avoid the stigma of a foreclosure and the impact a foreclosure can have on his or her's credit report (and score). Second, you work with the bank toward a sale. This arrangement gives the homeowner some control before vacating the house. Another benefit of a short sale is the possibility of purchasing another home sooner than giving up the home with a foreclosure.