In real estate, a short sale means selling a house for less than the outstanding mortgage on it.

Say Mr. and Mrs. Smith borrowed $400,000 to purchase a home seven years ago. The home was appraised at $400,000 at the time it was purchased. Mr. Smith loses his job and the couple is falling behind on their mortgage payments. Upon reviewing a comparative market analysis, the Smiths learn that the value of their home has dropped, and it is now worth only $310,000. Faced with $385,000 left on their loan, the Smiths prefer to sell their home, rather than seek government refinancing options like the federal Home Affordable Refinance Program, and ask their lender for permission to sell it for $310,000. When the home sells, the bank will get back less than the full amount the Smiths borrowed; in most cases, however, the lender will consider their mortgage paid in full.

The transaction benefits the bank by allowing it to avoid repossessing the home in foreclosure, which is expensive and time-consuming, and it benefits the seller by allowing him or her to avoid the negative credit ramifications of foreclosure (and the bankruptcy that sometimes accompanies it).

Short Sale vs. Foreclosure

Short sales and foreclosures are both financial options available to homeowners who are distressed borrowers: behind on their mortgage payments, have a home that is underwater (that is, worth less than the outstanding balance on the mortgage) or both. The owner is forced to part with the home in both cases, but the timeline and other consequences are different in each situation.

There are different reasons for why a homeowner would opt for a short sale versus a foreclosure.

Short Sale

Short sales are usually initiated by the homeowner, often when the value of a home drops by 20% or more. Before the process can begin, the lender that holds the mortgage must sign off on the decision to execute a short sale. Additionally, the lender, typically a bank, needs documentation that explains why a short sale makes sense; after all, the lending institution could lose a lot of money in the process.

If approved for short sale, the buyer negotiates with the homeowner first and then seeks approval on the purchase from the bank second. It is important to note that no short sale may occur without lender approval.

Short sales tend to be lengthy and paperwork-intensive transactions, sometimes taking up to a full year to process. However, short sales are not as detrimental to a homeowner's credit rating as a foreclosure is. A short sale looks better to future lenders and creditors: It shows you took action before the bank had to repossess your home. A homeowner who has gone through a short sale may even, with certain restrictions, be eligible to purchase another home immediately.

Foreclosure

A foreclosure is the act of the lender seizing the home after the borrower fails to make payments. This is the last option for the lender, since the home is used as collateral on the note. Unlike a short sale, foreclosures are initiated by lenders only. The lender moves against delinquent borrowers to force the sale of a home, hoping to make good on its initial investment of the mortgage. Also, unlike most short sales, many foreclosures take place when the homeowner has abandoned the home. If the occupants have not yet left, they are evicted by the lender in the foreclosure process.

Once the lender has access to the home, it orders its own appraisal and proceeds with trying to sell the home. Foreclosures do not normally take as long to complete as a short sale, because the lender is concerned with liquidating the asset quickly. Foreclosed homes may also be auctioned off at a "trustee sale," where buyers bid on homes in a public process.

In most circumstances, homeowners who experience foreclosure need to wait a minimum of five years to purchase another home, or three years with an FHA loan. The foreclosure is kept on a person's credit report for seven years. Your FICO score will drop by over 100 points due to foreclosures, according to Barry Paperno, consumer operations manager at Fair Isaac (it will also drop after a short sell, probably, due to you being in default on mortgage payments). This may seem like a relatively small amount for a default on a major asset, but it's enough to cause credit card companies to consider rate hikes and credit limit decreases, and for insurance companies to raise premiums.

How to Buy a Short-Sale Property

The short sale process varies from state to state, but the steps generally include:

  • Short sale package - A financial package is submitted by the seller to the lender. This includes financial statements, a letter describing the seller's hardship and copies of financial records.
  • Short sale offer - If the seller accepts the offer from an interested buyer, the listing agent sends the lender the listing agreement, an executed purchase offer, the buyer's preapproval letter and a copy of the earnest money check, and the seller's short sale package.
  • Bank processing - The bank reviews the offer and either approves or denies the short sale. This can take several weeks to months.

In some ways, buying a short-sale property is just like a traditional purchase. However, there are a couple of ways in which the purchase agreement you and your real estate agent draw up are different. The contract will specify that the terms are subject to the mortgage lender's approval. In a normal transaction, the only party who would need to approve the sale is the seller.

The contract should also state that the property is being purchased "as-is." While it is acceptable to include language that allows you to back out of a deal if an inspection reveals considerable problems, you should not expect to be able to negotiate a lower price because of them. The bank is also unlikely to make any repairs, and the seller, being strapped for cash, is probably even less likely to help out. Given the situation, you'll likely also need to have enough money for closing costs. (Keep reading about the closing process in Understanding The Escrow Process.)

Unlike foreclosure, the lending institution does not own the property in a short sale. However, because it must approve the sale (because it is the lender, not the seller, who will be taking a loss on the property), and will receive the proceeds, it will seem like you are purchasing the property from the bank.

A Waiting Game

Short sale transactions can be much more time-consuming and patience-testing than regular real-estate transactions. (Keep reading about this in Short Sell Your Home To Avoid Foreclosure.) If you make an offer on a short sale property, be prepared to wait. Banks are notorious for taking as long as several months to respond to short sale offers. Some experts recommend that you give the lender a deadline to reduce the wait time. though it's hard to say whether this strategy will really spur the bank to action. However, if the bank hasn't actually approved the short sale yet at the time of your offer, implementing a deadline will be useless as it may take several months just for the seller to reach a short sale agreement with the lender.

Seller Must Be in Official Default

For that reason, make sure the short sale is already lender-approved. If the seller has not actually gone into default yet, the bank may not be interested in doing a short sale. It takes a considerable amount of time and convincing to get a bank to agree to a short sale, so if it hasn't agreed already, don't waste your time. Many homes are listed as a short sale, but there is no guarantee that the transaction will ever be completed as such.

The bank may also not be interested in a short sale if it thinks it can get more money by going into foreclosure. And if you are seeking financing for the purchase, make sure your mortgage lender has no problems with a short-sell property.

Experienced Agents

Because of the complexity of this type of transaction, make sure your agent or realtor is experienced with short sales and is willing to work with you on one. Certain real estate agents specialize in short sales, and may hold a Short Sales and Foreclosure Resource (SFR) certification, a designation offered by the National Association of Realtors. Holders of this certification have received specialized training.

Not only are short sales more work for agents, they sometimes offer less compensation: The bank may not be willing to pay the listing agent the usual 5-6% commission because it is already taking a loss, and because the buyer's agent gets a percentage of that percentage, he or she will see even less money.

In addition, try to find out if the seller's listing agent is experienced with short sales. Although the bank is ultimately in control, a listing agent who knows the ropes may be able to facilitate or expedite the transaction.

Haggling Over Prices

Be prepared to raise your offering price. For the seller to increase the odds of the bank going through with the short sale, he or she may try to convince you to up your purchase price. Ultimately, though, the seller has no real authority to approve the selling price, only the bank does, and they may also counteroffer.

On the other hand, the bank just reject your offer outright, especially if you've written a significantly lower priced offer. Or, in the worst case scenario, they might not reply at all. Ever.

Keep the Search Going

Given how long it will probably take the bank to reply to your offer, you should probably keep looking at other houses while you wait for a response, and you should probably proceed with the purchase of another property if you find an easier buy. Have your agent write the short sale purchase agreement in such a way that you'll retain this flexibility. If you have a deadline for relocating, don't even bother with a short sale.

Another reason to keep looking: Even if you make it to escrow, the bank may continue to collect offers. Most people would consider this unethical because the potential purchaser is likely to have shelled out a few thousand dollars on inspections, title searches and the like, at this point. But remember the bank is facing a losing transaction, so it will want to minimize its losses and sell the property as close to fair market value as possible. Getting dropped from the deal so late in the game is a huge waste of time and money for the buyer, not to mention enormously frustrating. For all of these reasons, the listing price of a short sale must be taken with a healthy dose of skepticism.

Short Sales: the Pros and Cons

Experts disagree on whether short sales are a good deal for buyers. Proponents say that short sale properties are priced below market value, creating the opportunity for buyers to get a great deal or for first-time homebuyers to get into a home they otherwise might not be able to afford.

Opponents say that banks have no interest in doing fire sales, and will do a comparable market analysis before setting or accepting a price for a property. Further, the listing price of a short sale may be an amount the seller's agent thinks the bank might accept – rather than the amount the bank has actually agreed to accept. The bank might find the price too low, or the seller might list the property below market with the intention of generating a bidding war. In some states, the seller will have a deficiency judgment against him, which obligates him to pay the bank back the difference between the mortgage amount and the sale price of the home, so it's in the seller's best interest to get as much money as possible.

One advantage to both the bank and the buyer is that unlike a bank-owned property, a short sale property is less likely to be trashed or ransacked. While the property may be suffering from deferred maintenance because of the owner's financial situation, the seller is not likely to destroy the place when he or she still lives in it. By contrast, homeowners who lose their properties to foreclosure often take out their frustration on the house as a way of getting back at the bank.

Along the same lines, because short sale properties are still occupied, they won't have suffered at the hands of unscrupulous people who have chosen to squat in or vandalize the property. Vandalism can be a common problem with foreclosure properties, especially in lower-income neighborhoods.

Finding Short-Sale Listings

Most properties offered as short sales are listed by real estate agents, and this often represents the best place to start, especially if it's a realtor who specializes in them. Without an agent, you can easily search the Multiple Listing Service (MLS) from the comfort of your own computer (or mobile device), but the data you access may be limited in scope, outdated or even inaccurate.

While you can find some short-sale properties on popular real estate websites like Zillow and Trulia, other sites that specialize in foreclosures and discounted properties offer a more comprehensive view of the short-sale market in your area. One such website is www.realtystore.com, which has more than one million listings of foreclosure auctions, bank-owned properties, government repossessed homes, tax-defaulted properties and short sales.

The Bottom Line

A short sale can benefit all the parties involved: Lenders avoid the lengthy and costly foreclosure process; borrowers keep foreclosures off their credit reports; and buyers may be able to purchase properties at reduced prices. A buyer shouldn't assume the property is a great deal just because it is a short sale, however. Do your own comparable market analysis. Also, if you make it to escrow, don't skip a thorough home inspection.

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