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Since the real estate crisis sunk housing values throughout the country, millions of homeowners have found themselves underwater: a situation where they owe more to the bank than the property is actually worth. When someone in that situation is forced to sell — maybe they’ve lost a job and can’t pay the mortgage, or perhaps they have to move for a new job — their only option (besides a foreclosure or handing over the house keys to the bank in a so-called deed in lieu of foreclosure) is to convince the bank to agree to a short sale.
Don’t think a short sale is an easy way out of an underwater mortgage. On the contrary: the process is complicated, long, and will have negative ramifications for both your credit and finances.
Pros and Cons
For a homeowner, the benefits of a short sale seem worth the hassle of going through what is most commonly a lengthy, frustrating process (we’ve given you the step-by-step guide at the end of this article).
A short sale:
– Eliminates the negative equity burden.
– May enable them to qualify for a new mortgage sooner than with a foreclosure or bankruptcy on their credit file.
– Allows homeowners to repair their finances by reducing their housing payments.
However, there are significant drawbacks to short sales that everyone should carefully consider:
– A tarnished credit history and score.
– Diminished financing options on real estate for a minimum of two years.
– Lenders may pursue the so-called deficiency balance after the sale.
– Income taxes may be due on the amount of forgiven debt.
– The approval process can be time-consuming and frustrating.
Who Should Consider a Short Sale?
A short sale certainly isn’t the miracle cure to underwater mortgages, but it is a valid option for some homeowners: one that should be weighed carefully. Because of the negative impact on one’s credit, homeowners should view short sales as a last resort, along with the prospect of foreclosure or deed-in-lieu of foreclosure.
Prime candidates for short sales will be in a situation where they are unable (or soon unable) to make their mortgage payments as agreed and have negative equity in their property. Homeowners who have to move because of a job or family situation would also be good candidates. Typically, however, lenders require the borrowers to demonstrate that they cannot continue to make payments or make up the difference in the mortgage in order to agree to a short sale.
A short sale may not be an option for homeowners who are currently delinquent on their mortgage and already facing foreclosure. Those homeowners are already short on time — and the short sale process is anything but: it will likely take months and multiple levels of lender approval to complete.
Unfortunately, lenders are in no way obligated to forestall the foreclosure process because the homeowner is pursuing a short sale. And even if the borrower is able to negotiate terms with a lender, there are considerable implications to consider.
The Credit Impact of a Short Sale
The exact impact on a homeowner’s credit score is hard to determine because a credit score incorporates a person’s entire credit history. One thing is for sure, though: according to FICO, the company that calculates the most widely-used credit scores, a short sale is considered a serious delinquency and has the same impact to one’s FICO score as a foreclosure, deed in lieu, or debt relieved through bankruptcy.
In fact, FICO recently published details on the impact of short sales (and other mortgage delinquencies) on FICO scores on its Banking Analytics Blog. According to that release, a consumer with a 720 score could see a drop to 570-590 as a result of a short sale with a deficiency balance; their score would then take about seven years to recover. The impact is exactly the same as that of a foreclosure.
(Despite the equal hit on the credit score, however, most mortgage lenders will be more lenient with a prior short sale than with a prior foreclosure. Fannie Mae underwriting policy requires borrowers with a foreclosure on their credit report card to wait a minimum of seven years before qualifying for a new mortgage. On the other hand, borrowers with a short sale only have a relatively short two-year wait period.)
All Other Financial Implications
Short sales have financial ramifications that go well beyond the impact on your credit score and ability to qualify for a mortgage. Some states, known as recourse states, allow lenders to collect deficiency balances from the borrower after the transaction closes. (To see if your state is in this group, check out this site.) Lenders can ultimately pursue a deficiency judgment, which could force short sellers who can’t pay the difference into bankruptcy. If you do live in a recourse state, you should negotiate with your lender to get an agreement in writing saying that they will not pursue the deficiency balance.
In the case that your short sale deficiency is forgiven, or if you live in a non-recourse state where deficiencies cannot be recovered, next in line for your money may be Uncle Sam. The IRS considers forgiven debt to be taxable income. One piece of good news: as a result of the financial crisis, Congress enacted a law to protect many homeowners. According to legal publisher Nolo, the debt forgiven may be excluded from income under the federal Mortgage Forgiveness Debt Relief Act of 2007 under the following circumstances:
– The forgiven debt was used to buy, build, or substantially improve your home or to refinance debt incurred for those purposes.
– The debt was forgiven between 2007 and 2012.
– The discharge was directly related to a decline in your home’s value or your financial condition.
It goes without saying that if you are not absolutely sure about your state’s laws or impact on your tax bill, you should consult a real estate attorney or CPA.
The Short Sale Process
While the government announced last month that they are working on enacting legislation to regulate the short sale process, this has not happened yet. Until it does, keep in mind that every lender has a different process. Here are the basic steps:
– Contact the lender. Since short sales aren’t necessarily in the best interest of the lender, don’t expect the lender to return your phone call the same day… or the next. Be persistent. You may need to speak with multiple people before you get to the right person who can help. Generally, you’ll need to provide all of your financial information to the lender, and they may deny the application if they believe that you would be able to continue to make your payments.
– Submit a letter of authorization. If you want your lender(s) to work directly with your real estate agent or attorney, you’ll need to give them a letter authorizing that.
– Provide a hardship letter. You should write a letter to your lender clearly explaining your financial hardship and how that leaves you with no choice but to consider short sale.
– Provide your financial documents. Your lender will want all of your financial information in order to complete the approval process. You’ll need to provide paystubs, tax returns and statements for your bank and investment accounts. If your lender deems that you could afford to continue to make payments, they may reject your request. Honesty is the best policy here as banks can easily detect under-reporting of financial information.
– Provide a preliminary net sheet. Once a buyer is identified, you’ll need to provide an estimated closing statement that sets out exactly how the funds will be appropriated between the lender and other interested parties, such as real estate agent, title and closing fees, the attorneys, etc.
– Negotiate the terms. Be sure that you get in writing that your lender will not pursue a deficiency judgment against you after the short sale. Although unlikely to succeed, you may try to negotiate to keep the lender from reporting the short sale to the credit bureaus.
– Lender Approval. The lender will carefully review and potentially counter-offer your requested terms. Be prepared for several levels of lender approval prior to acceptance.
