If you’re having trouble meeting your monthly loan payments and are now facing foreclosure, a short sale may be a better option. Let’s look at the basics of the short sale process, including how to determine whether you qualify, the pros and cons of short sales and the procedures involved in completing a short sale.
What Is a Short Sale?
A short sale is the process in which a homeowner sells their home for less than what they owe on the mortgage or for less than the property’s currently worth. The mortgage lender permits the sale—or in some cases, purchases the home from the borrower—and may forgive the shortage.
Short Sales vs. Foreclosures: What’s the Difference?
Both short sales and foreclosures are processes designed to resolve situations where homeowners are unable to meet their financial obligations to their mortgage lender, and both result in the loss of the property for the homeowner. However the procedures and financial outcomes differ significantly.
In a short sale, a homeowner in financial distress sells the house (often to a third party) for less than what’s owed to the lender. The homeowner then hands over the proceeds from the sale to the lender and the lender absorbs the remaining debt above the short sale price.
In a foreclosure, the bank repossesses the home after the homeowner fails to make monthly payments for a certain length of time. The lender then sells the house and retains the right to sue the homeowner for the difference between what the home sold for and the outstanding mortgage debt.
When Is a Short Sale Better Than a Foreclosure?
If you’re unable to meet your monthly mortgage payments, the worst thing you can do is nothing, which generally results in the lender initiating a foreclosure against you. A short sale is an alternative process that offers considerable advantages over a foreclosure, including:
- Eliminating your debt despite selling your home for less than you owe
- Minimizing the impact to your credit score (compared to foreclosure)
- Being able to stay in your home until the sale closes
- The potential availability of cash relocation incentives
What Are the Disadvantages of a Short Sale?
Although a short sale is generally preferable to foreclosure, these disadvantages are worth considering before making a decision:
- Getting approved can require approval from the mortgage investor
- The process may require financial review
- Lienholders still may be able to sue you for deficiency, i.e. the difference between their share of the short sale proceeds and what you owe them
- Your “forgiven” debt may end up costing you at tax time, as it can be considered taxable income*
- If a buyer backs out, the entire short sale process must start all over again
Do I Qualify for a Short Sale?
To qualify for a short sale, you’ll typically need to meet each of the three conditions below.
1) Financial hardship
A financial hardship is an unexpected circumstance that hinders your ability to make mortgage payments on time. Some examples of financial hardships include the loss of a job or income, relocation, illness, divorce or death.
2) Financial Insolvency
Insolvency means you are unable to meet your financial obligations as they become due. However, you do not need to be completely out of cash to be considered insolvent. For example, having some cash in the bank for day-to-day living expenses will not disqualify you from obtaining a short sale.
3) A Monthly Deficiency
To determine if you are currently suffering from monthly financial deficiencies, simply add up your monthly expenses and compare that number to your monthly income. If you can't pay your bills, or if it's clear that you will have difficulty doing so in the future, then you likely meet this condition.
Additional Short Sale Documentation Requirements
It’s not enough just to check yes next to each box, however; for your lender to consider your short sale, you’ll need to provide proof of your financial hardship. While banks may vary slightly on the type of proof required, you can count on being asked to supply, at a minimum:
- Pay stubs
- Tax returns
- Bank statements
- Disclosure of assets such as retirement accounts, stocks and bonds, annuities, etc.
Understanding the Short Sale Process
While different banks may do things slightly differently from one another, the basic short sale process remains largely the same in most cases. Here’s an overview of the standard short sale process.
- 1) Begin working with your lender. You’ll need to provide all your financial documents, as well as details of the hardships that led to your request, and sign a letter authorizing your real estate agent to speak to the bank during the process. The investor of your mortgage must approve the short sale transaction.
- 2) Collaborate with your real estate agent. Together, you’ll work to determine your home’s fair market value (which can be less than what you owe on the loan). Then, you’ll list your home for sale.
- 3) Your lender reviews any offers. Once an offer has been received, your lender will review it. If the offer is approved, your real estate agent will receive the closing instructions. However, it’s important to note that your approval letter may have a deadline. If the buyer backs out or doesn’t close before the approval’s expiration date, you’ll have to start over from square one.
- 4) Close the deal. You and the buyer will agree on a closing date, the funds will go to your lender, and the matter is considered settled according to the terms of your short sale agreement.
After You’ve Sold in a Short Sale
A short sale, while unfortunate, doesn’t mean you’re destined to rent for the rest of your life. These following four steps will have you back on the path to homeownership in the least amount of time possible.
1) Confirm the Short Sale was Reported Correctly
Ask your lender for a short sale letter and check that the sale was properly reported to the lender, your bank, and each of the three US credit bureaus.
2) Manage Your Credit
Short sales can affect your credit as much as a foreclosure does, but that doesn’t mean you can’t start improving your scores right away. There are a number of credit improvement strategies that can help get you on the path to buying a home after a short sale. Here are a few you can begin right away:
- Pay your bills on-time, every time.
- Be careful when applying for new credit since inquiries harm your credit score.
- Using as little of your credit limits as possible.
- Do not close existing credit cards, since the higher your (unused) credit limit, the better off you usually are.
3) Be Prepared to Wait for Your Next Home Loan
Most lending programs have waiting periods during which they won't lend to you. Borrowers who go through a foreclosure typically must wait seven years before they’re eligible to apply for a mortgage again. Short sellers, on the other hand, may qualify again after just two years. These programs and rules change periodically, so it's always best to check with an expert mortgage lender. Here are some rules of thumb for different programs:
- Conventional Loans: Two to seven years, depending on how large of a down payment you can make.
- FHA Loans: Three years.
- VA Loans: Two years.
4) Get Pre-Approved for a New Home Loan
When you think you'd like to consider buying a home after a short sale, talk to a mortgage lender about getting pre-approved. The lender can review the available programs and your situation and let you know if your situation fits with the lender's timeframes. If it does, the loan officer can look at your credit and income and, if you qualify, give you a pre-approval.
Are You Ready for a Short Sale?
For people having trouble paying their mortgage, a short sale offers many benefits over a foreclosure. Although the process can be lengthy and frustrating, you can sell your home for less than what you owe, and in most cases, walk away without having to worry about paying the difference.
While the process may seem cut and dry in black and white, it’s not as simple as it seems. Learn more about how PennyMac handles short sales, or a contact a qualified PennyMac Loan Officer today and let us help find a solution that’s best for you!