Chances are you’re familiar with foreclosures. Something about how if a homeowner can’t pay the mortgage, the lender takes the house.
But what’s a “short sale”? Can it prevent a foreclosure? Can it save a homeowner a ton of money? And on the buyer side, should you consider buying a short sale or foreclosed home for a killer deal?
Let’s investigate short sales and foreclosures.
What Is a Short Sale?
A short sale is when a homeowner chooses to sell their home for less than they owe on the mortgage.
For example, if a homeowner and her husband both lose their jobs in the same week — and after several missed payments she realizes it’s unlikely they will be able to catch up — she might call up their lender, explain the situation, and request a short sale in order to avoid foreclosure.
As a quick FYI, owing more than your house is worth is called being “underwater.” This term also applies to any loan where the market value of the asset is less than the outstanding loan amount — meaning if you sold it, you’d still owe your lender money.
So why would someone consider selling their home while they’re underwater?
Read more: Mortgage Underwater? Here Are Your Options
When Would a Short Sale Make Sense?
The #1 reason to do a short sale is to avoid foreclosure.
As we’ll discuss below, regular foreclosures are nasty business for both homeowners and lenders alike. They involve the lender seizing the property after too many missed mortgage payments, which devastates the owner’s credit score and can cost the lender tons of time and money.
So if a homeowner misses their first mortgage payment and they know they’re going to miss more, they might call up their lender and say, “Hey, so we lost our jobs and definitely can’t afford our mortgage now. Will you let us sell the house at a loss so we can both avoid a foreclosure?”
Then, a lender will usually say, “Yes. So glad you called. Let’s work it out.”
The process is more formal than that, of course, but hopefully that approximation makes sense.
What Are the Requirements of a Short Sale?
As hinted, short sales require lender approval.
You’ll typically have to document the reasons for requesting the short sale in a “hardship letter” to your lender. These reasons might include:
- Proof of job loss, disability, or health issues
- Tax returns
- Divorce paperwork
- Updated account statements
- And more
If your lender approves of the short sale, you’ll then negotiate what to do with the “deficiency amount,” or the amount you’ll still owe them after the sale.
For example, if your house is worth $200,000 and you owe $220,000 on the mortgage, lenders will often just say, “Look, we appreciate your honesty, so don’t worry about the $20K.”
If there’s a bigger gap, your lender might agree to a prearranged settlement — say, 50/50 of the final deficiency.
In rare cases, lenders won’t forgive deficiencies at all, and file a “deficiency judgment” to make you legally liable for the difference. This can happen if they think you’re dishonest and/or can afford the difference. However, six states (AK, CA, MN, MT, OR, and WA) forbid deficiency judgments in most cases according to Rocket Mortgage.
Once your lender has approved of a short sale — and you’ve both agreed to deficiency terms — you’ll work with your realtor to post a short sale listing (more on the buying process later).
Next, you’ll pass along offers and buyer profiles to your lender for their final signoff. The sale proceeds then go directly to your lender, not you.
Finally, once the sale goes through, short sellers have a four-year waiting period before they can apply for a conventional loan again.
When Would a Lender Reject a Short Sale Request?
Sometimes a lender will reject a short sale request altogether. Naturally, most of these rejections are motivated by money, and how much money the lender can recoup. Here are some reasons why a lender might reject a short sale request:
The homeowner hasn’t missed payments yet. It may sound counterintuitive, but many lenders won’t let you apply for a short sale until you miss payments — even if you can prove now that you will miss payments in the future. But be sure to confirm that this is the reason for the rejection before risking your credit score on a missed payment.
There’s a chance to salvage the mortgage. On a positive note, a lender might consider loan modifications (expanding your term, lowering your interest rate) to make your mortgage more affordable.
There’s a co-signer. Lenders are less sympathetic to hardship letters if there’s a co-signer on the mortgage that they believe can afford the monthly payments.
They’ll get more money from a foreclosure. If a lender thinks they can get a higher price within their own network — or if they want the property for themselves — they might force a foreclosure.
They don’t trust the borrower. A lender might find it easier to evict a dishonest borrower than to try and negotiate with them.
What Are a Homeowner’s Options If They’re Rejected for a Short Sale?
Lenders are heavily incentivized to approve short sales. Generally speaking, they’ll work with you to make it happen.
Here are some next steps you can take if you’re initially rejected:
- Talk to your lender’s loss mitigation department to ID what went wrong. They’re the ones who will have quick answers and will help you out.
- Consider a deed forfeiture. If your lender won’t approve a short sale, you can ask if they’ll just accept the deed in exchange for canceling the mortgage.
- Get a co-signer. To avoid foreclosure, you might be able to find a co-signer who can help you with monthly payments until you’re back on your feet financially.
Whew. So that’s the skinny on short sales. Let’s talk about its ugly twin, the foreclosure. The only nice thing about foreclosures is that they’re easier to explain.
What Is a Foreclosure?
A foreclosure is when a homeowner misses too many mortgage payments, forcing the lender to evict them, seize the property, and resell it to recoup as much of the original loan amount as possible. Sometimes a lender even has to involve the local sheriff’s office to physically remove a homeowner and their belongings.
Like I said: Nasty, nasty business.
Foreclosures are a lose-lose scenario for both the homeowner and their lender:
The homeowner loses their primary residence, suffers a massive drop in their credit score, and will be unable to reapply for a conventional home loan for seven years until the foreclosure falls off their credit report. In fact, they may also struggle to get any kind of loan for seven years. As Experian puts it, “lenders consider foreclosure a serious derogatory event in your credit history, second only to bankruptcy.”
The lender loses time, work hours, and tons of money managing the legal process of a foreclosure, repairing/maintaining a vacant property, and selling it at a loss.
As a result, a lender is just as keen to avoid a foreclosure as a borrower — which is why they’re often grateful for the short sale conversation.
What Are a Homeowner’s Options If a Lender Initiates a Foreclosure?
For starters, a foreclosure notice should never come as a surprise.
Under federal law, lenders can’t start the foreclosure process until 120 days have passed since a homeowner’s first missed mortgage payment. If you get a notice before then, it’s most likely a scam — but call your lender to confirm.
While you’re on the phone with your lender, ask them for options and guidance to avoid foreclosure. They may seem like the bad guys, but remember, they want to avoid foreclosure, too.
Oftentimes, one of the following options will emerge:
Apply for a short sale. Some lenders will suspend a foreclosure in favor of the chance of a short sale.
Apply for a loan modification. As mentioned above, a loan modification means your lender can change your term, interest rate, or more to salvage the relationship, so to speak.
Get a co-signer or family loan. Getting a traditional loan can be nearly impossible while you’re battling foreclosure. But a friend or family member may still be willing to front you some cash — or even co-sign — to help you avoid losing your home.
And just to be clear, you can also stop a foreclosure by paying back your missed payments.
Read more: Should You Get a Co-Signer on Your Mortgage?
Short Sales vs. Foreclosures: Key Differences
Short sales and foreclosures share some DNA, so let’s isolate the key differences:
The Initiating Party
Perhaps the biggest difference between a short sale and a foreclosure is who initiates it.
- Short sales are initiated by the homeowner.
- Foreclosures are initiated by the mortgage lender.
Short sales still require lender approval, but they’re set in motion by the homeowner.
None of the lenders I spoke to could think of a time where a lender actually recommended a short sale to a borrower. It just doesn’t happen, so it’s up to the borrower to broach the topic once they’ve missed a payment.
Short sales tend to move more quickly than foreclosures. Here’s a typical timeline for a short sale, courtesy of Jeff Cook Real Estate.
- Hardship letter prep: 1-3 weeks
- Property valuation: 1-3 weeks
- Negotiations between buyer and lender: 1-3 weeks
- Escrow and close: Up to 6 weeks
In total, a short sale can take between two and four months, largely depending on how quickly the lender communicates and responds to offers.
By contrast, foreclosures are grueling, lengthy efforts that can last for years. Here’s a rough timeline, courtesy of Attorney Stephanie Elias and The U.S. Department of Housing and Urban Development:
- Foreclosure notice: At least 120 days after first missed mortgage payment
- Eviction notice: 30 days later
- Actual eviction: Whenever the local sheriff is available (weeks? months?)
- Foreclosure sale: Anywhere from weeks to years
If a foreclosure gets stuck in court, or a property gets damaged by the tenant or a lack of maintenance, it could take years before the lender can sell it.
Finally, short sales and foreclosures look different on your credit report, i.e., your “borrower’s report card” that other lenders see before loaning you money.
Surprisingly, FICO data shows that short sales and foreclosures have a similar negative impact on your credit score: Both lead to a drop of between 90 and 150 points.
And while both are considered “significant derogatory events” on your credit report, foreclosures have a seven-year waiting period before the borrower can apply for a conventional loan again, compared to four for a short sale according to Fannie Mae.
Should You Buy a Short Sale or Foreclosed Home?
No. It’s just not worth the risk and the hassle.
“It’s a laborious, laborious process. I’d really only recommend it for advanced investors with a lot of patience,” said Joseph Elkourie, founding member of The Axis Group by Compass, in an interview with Money Under 30. “Distressed properties are not a great option for first-timers.”
Short sale homes may lack care and maintenance, but the bigger issue is timing.
“It’s not uncommon to wait weeks, even months for banks to respond to short sale offers from buyers. I’ve offered sellers full value — no delinquency — and it still took their bank four months to get back to us.”
Banks are often more keen to sell foreclosures, but for a sobering reason.
Mark Milam, Founder of Highland Mortgage, warns that “foreclosed homes often get torn up by tenants or sit vacant with the utilities cut off, developing mold, pests, you name it. The value of the asset really starts to depreciate and affect surrounding homes.”
Short sales and foreclosures may be cheaper, but they take longer and you get what you pay for.
Dang, I Was Really Hoping to Get a Good Deal on a Home…
You still can!
Buying a home in 2022 isn’t impossible — just more challenging than it was a few years ago. But you can do it.
“If my own children were ready to buy in 2022, I wouldn’t dissuade them from doing so,” Mark said.
Short sales and foreclosures aren’t particularly appealing endeavors, but the former can be a valuable tool for avoiding the latter.
A short sale can save a homeowner time, tens of thousands of dollars, and shrink their waiting period before they can apply for another mortgage.