Short Sale Questions and Answers!
Is a Short Sale RIGHT for the Borrower?
This is a question often asked by both people facing foreclosure.
Why would someone sell his or her house utilizing a Short Sale method? To put it simply, to avoid a foreclosure on the homeowner’s record and to decrease the length of time a lender will require prior to lending to the borrower again and the cost of a reduced credit score. How long? Lenders indicated 18 – 24 months of “Good” payment history on the borrower’s credit report for individuals who went through a short sale compared to 3 to 7 years for those that went through a foreclosure.
It isn’t often in real estate transactions that virtually all parties with a financial interest can be winners in the same transaction. A successful Short Sale is one of those rare situations where everyone wins.
The Seller Wins by avoiding foreclosure and all the credit damage that goes along with it. The property gets sold, all the loans get paid off, or forgiven and the existing lender pays all the sales costs. In most cases, the Seller has no out-of-pocket expenses.
The Mortgage Holder Wins by reducing the loss they absorb to get the delinquent loan off their books. Mortgage companies know that the costs associated with acquiring a property through a foreclosure hit their bottom line — hard. To resell the property, the mortgage company frequently needs to invest money in clean up and repairs, and they need to pay staff to manage and maintain the property as well. This is precisely why they have set up Loss Mitigation Departments to resolve delinquent mortgages before the foreclosure is complete.
The Buyer Wins by acquiring a property at below market price. While some Short Sales will be bigger bargains than others, nearly all Short Sales will represent a good deal for the buyer. This is especially true for buyers who intend on making the property their personal residence.
Why would a lender accept a short sale?
In today’s economy of rising foreclosure rates, most mortgage lenders are increasingly willing to work with borrowers faced with a financial hardship to accept a discounted payoff on a mortgage, more commonly referred to as a short sale. If a borrower is faced with a hardship that makes it likely that they will be unable to meet their obligation on their mortgage the lender typically prefers to settle the matter as opposed to taking the property through foreclosure.
If a lender does take back the property there are not any guarantees that they will recoup their cost and have their original loan paid to them when they sale the foreclosure property. Keep in mind, the lender would become responsible for a variety of costs, including property maintenance, utilities, HOA fees, and might risk destruction of the property by vandalism. Furthermore, lender-owned properties (REO) may take a long time to sell, in part because so many REO properties are now for sale.
Not to mention the reserve requirements. For a loan which is in “Normal” status, meaning that the borrower is making on time payments and is not delinquent or in foreclosure banks, must hold in reserve a certain percentage of their deposits. This number is usually around 3 percent of the deposits on hand. The issue is that banks must keep a reserve against anticipated losses. In fact, in the state of California, newly chartered state banks need to set aside reserves against loan losses equal to 5 years worth of losses for banks of similar size.
For all delinquent and non—performing loans lenders must set aside funds in reserve to deal with potential losses. Because of this, the lending power of a bank is diminished and the loss to the banks of their ability to make additional loans utilizing the same amount of reserve is extremely hampered.
If mortgages perform poorly after they are sold, it could impact the lender’s ability to sell their loans on the secondary market. A successful Short Sale gets the loan payoff resolved quickly.
Lender’s Options upon Borrower’s Loan Default
In order for a lender to recover their outstanding loan balance of a non performing loan, the lender may begin the foreclosure process and seize the property. To do this, the lender must foreclose on the defaulting borrower’s real property which secures the loan.
In the state of California, there are two types of “foreclosures”: A trustee’s
sale and a judicial foreclosure.
On certain loans, a lender has no choice and must conduct a trustee’s sale. With a trustee’s sale, a lender cannot go after a deficiency judgment. A deficiency occurs when the current market value of the property is less than the loan on the property.
Basically, the borrower and the lender work out a modification of terms of the original loan agreement. Some of these options may include a forbearance agreement, deferment of outstanding loan payments, renegotiating the loans interest rate, which affects the monthly payment amount, even reduction of principal amount and loan payoff date.
A Forbearance Agreement is a written agreement with your mortgage
company in which you arrange to keep your home. The agreement will
normally include two primary elements:
The borrower’s promise to remain current on the mortgage going forward Some plan for making up the delinquent interest and other charges. It may mean making additional payments to the mortgage company or the delinquent amount could be added to the loan to be paid later.
Deed in Lieu of Foreclosure:
A deed to real property accepted by a lender from a defaulting borrower to avoid the necessity of foreclosure proceedings by the lender and cost associated to a foreclosure.
A short sale is a transaction in which a lender allows the real property securing the loan to be sold for less than the remaining mortgage amount due and accepts the proceeds as full payment of the loan.
With a short payoff, the lender accepts less than the remaining mortgage amount as full payment of the loan. The property need not be sold. Just a note however, that some lenders do not differentiate between a short sale and a short payoff.
How is the Borrower’s FICO score affected?
The disadvantage for a seller who has a foreclosure is much greater over a seller who goes through a short sale. Here are the numbers involved:
Foreclosure on the Credit Score
A seller who goes through a foreclosure and has a foreclosure on their record may have a reduction of 250-280 points on their FICO. If the borrower started off with a FICO score of say, 725 prior to a foreclosure, after a foreclosure is posted against their credit score their FICO could be severely less then 500. What is worse, is that the foreclosure will be on their record for 7 years.
Short Sale on the Credit Score
The affect of a short sale on a Borrower’s credit report is much less damaging and the light at the end of the tunnel is much brighter. First, the short sale will show up on the borrower’s credit repost as a pre-foreclosure in redemption status rather then a completed foreclosure. The reduction of the borrower’s credit score is typically only 80-100 points. The above example would be a reduction from 725 on the FICO score to only a 625 FICO score. As you can see, the difference between a 625 FICO score and a sub 500 FICO score is tremendous.
Is the method by which lenders report a short sale a negotiable item?
Typically speaking, no. The short sale is usually reported to credit reporting agencies as settled for less than the full balance. Remember, the short sale shows up as a pre-foreclosure in redemption not a foreclosure.
What is a deficiency judgment?
A deficiency judgment is a judgment obtained by the lender in court against the borrower for the difference between the unpaid balance of the secured debt and the amount produced by sale or the fair market value of the security, whichever is greater, in a judicial foreclosure. A lender may obtain a deficiency judgment only with a judicial foreclosure. With a trustee’s sale foreclosure, the lender cannot go after a deficiency judgment.
There are five situations in which a deﬁciency judgment may not be pursued:
- Trustee’s Sale — A lender may not pursue a deﬁciency judgment against the borrower should the lender opt to foreclose by a trustee’s sale foreclosure.
- Seller Carryback — If the purchase money loan for any type of real property is financed by the seller and secured by that same property, the lender/seller may not obtain a deficiency judgment against the defaulting borrower/buyer.
- Purchase Money — If the loan is obtained to purchase a residential 1-4 unit dwelling all or part of which is owner occupied and the loan is secured by that property, the lender may not obtain a deficiency judgment against the defaulting borrower. This loan is entitled to “purchase money” protection. Note, however, that should the buyer refinance the home, the new loan is no longer “purchase money.” Thus, the buyer would lose the protection against a deficiency judgment in the event of a default if the lender elects to use a judicial foreclosure process.
- 3 Month Time Limit — An action for a deficiency judgment must be brought within 3 months from the time ofjudicially-ordered sale.
- Fair Value Limitations — A deficiency judgment is limited by the difference between the amount of the indebtedness and the fair market value of the property, unless the actual sale price exceeds that value.
Holders of a junior deed of trust (second, third, etc.) should note that if the “wiped-out”junior lien is not purchase money or seller carryback, then the junior lien holder may sue on the note and the borrower on the junior loan may be personally liable.
What are the hardships that a bank looks at as justification for approving a Short Sale?
(See our earlier blog post about writing a Hardship Letter for more tips!) The borrower must have a legitimate excuse for falling behind… The inability to pay the mortgage, the loss of a job, death in the family or an illness would be an acceptable reason to fall behind on your Mortgage temporarily.
A big key to getting Loss Mitigation to accept a hardship is to submit a strong hardship letter. The hardship letter sets the tone for the entire file.
- Family illness or injury
- Illness or injury in the extended family — particularly if it forces relocation
- Job relocation when the property is equity deficient
- Job loss or significant income loss
- Divorce or split of domestic partners
- Adjustment in mortgage payment or unforeseen increase in living expenses
Also keep in mind that if the borrower has other assets, like real property, or the ability to borrow money the lender is not going to accept borrower as having a hardship.
I am current on my mortgage; will my lender consider a Short Sale?
The answer is, maybe. Some lenders will accept a Short Sale file for approval on loans that are not delinquent. Other lenders will not accept the ﬁle until the loan is delinquent.
There are two loans; can a Short Sale still be accomplished?
Yes. You can work with both lenders (many times the same lender holds the 1st and the 2nd loans) to put together a Short Sale transaction. Even if the value of your home is below the balance of the 1st mortgage, you can normally get the two lenders to cooperate.
The property is in rough shape and needs work; can I still do a Short Sale?
Absolutely. In fact, lenders are more motivated to do a Short Sale on a property that needs work than on a property that doesn’t. The lender knows the risk of loss goes up when they foreclose on a property that needs a lot of work.
Aside from expense of completing the work, lenders are simply not set up to get the work done. They are in the loan business, not the fix- it business.
The process is a difficult process to say the least. It requires training and understanding of the laws and lender procedures.
What are the tax effects of a short sale?
Great news has come out of Washington that help people facing foreclosure or short sale. Until recently, if the value of a borrowers house declined and their bank/lender forgave a portion of their mortgage (via a short sale or deed in lieu), the tax code treated that amount forgiven as ordinary taxable income.
For a borrower already financially strapped, this makes a bad situation worse. When a borrower is worried about making their payments, higher taxes are the last thing you need to think about.
On December 20, 2007 the “Mortgage Forgiveness Debt Relief Act of 2007″ became Public Law No: 110-142. The law is retroactive to January 1, 2007 and will extend until December 31, 2009. The passing of this bill creates a three-year window for homeowners to either refinance their mortgage or sell, and pay no taxes on any debt forgiveness that they receive.
The newly-enacted relief for mortgage debt forgiveness is Congress’s response to the problems generated by the subprime crisis, short sales, rising foreclosure rates and price corrections in some markets. Thus, when a lender forgives some portion of a borrower’s mortgage debt in a short sale, a foreclosure, a workout with the lender or some similar circumstance, the borrower will NOT be required to recognize income or pay tax on the forgiven amount.
Here is an excerpt of the law:
“Mortgage Forgiveness Debt Relief Act of 2007 — Amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge, prior to January 1, 2010, of indebtedness incurred to acquire a principal residence. Limits to $2 million the excludable amount of such indebtedness. Reduces the basis of a principal residence by the amount of discharged indebtedness excluded from gross income. Disallows an exclusion for a discharge of indebtedness on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer. Sets forth rules for determining the allowable amount of the exclusion for taxpayers with non- qualifying indebtedness and taxpayers who are insolvent. Extends through 2010 the tax deduction for mortgage insurance premiums.”
It is strongly recommended that the borrower seek the advice of a professional tax adviser.
If a borrower does do a Short Sale, how much will they have to pay to sell their home?
Zero. A borrower cannot pay, nor receive, any proceeds from the short sale of real property. All costs, commissions, title, escrow fees, repairs and such are paid by the lender as part of the Short Sale approval.
The agreement to sell is subject to approval by existing lender(s) of a Short Sale at no cost to Seller. Seller shall not be required to deposit funds to close escrow.