Short Sales – The Basics
The total short sale story is a long one. And that’s without getting into the complexities of seconds, equity loans, previous refi’s with Cash-Out, etc. So, we won’t “boil that ocean” - let's just “warm the pond”. Here's a simple explanation covering the typical situation - how to dispose of an “upside-down” primary home (and usually a second home) when it’s value is less than the mortgage balance.
Aren’t short sales bad for neighborhood values? Before we start, let’s address that issue. While short sales often result in an artificially low price, appraisers are supposed to make appropriate adjustments if they use them for price comparisons (“comps”) in determining the value of your home.
Of course, the alternative to a short sale, a foreclosure, usually results in the lender ending up with an REO (“Real Estate Owned”) on their books. This results in even lower pricing. Once a lender forecloses on a property, the Real Estate Owned department takes over and their mission is to deeply cut the price to get that nonperforming asset off the books ASAP (appraisers are supposed to adjust those prices for comps also). So, who wants more deserted REO's with dead lawns in their neighborhood? Short sales are the better alternative for neighborhood values.
One other alternative exists – a Deed In Lieu of Foreclosure (DIL) where the home owner simply signs over the home to the lender. Lenders like it because it’s simple and takes as little as 30 to 45 days. Homeowners like it since it takes all the work out of their hands – no dealing with real estate agents or haggling with buyers or living with an underwater property looming over their heads. Plus, many lenders offer a few thousand as a cash incentive. The downside is that it still results in the same credit hit as a short sale or foreclosure (see “What’s the final credit impact” below) and the other downside is that it necessitates a prompt move-out. A short sale can leave the owner in the property rent-free for months and a foreclosure usually takes even longer.
What is a short sale exactly? It is when the lender will allow the sale of the house at less than the amount to pay off the mortgage balance. Why would they do that? Because the owner is having trouble making payments and is headed for a foreclosure. So lenders, rather than go through the expense, time and trouble of a foreclosure plus having a problem REO on their books plus end up taking a big loss when they finally sell the REO, are usually willing to work out a short sale with the owner. (Plus the Feds are leaning all over them to do so).
Does this stop a foreclosure process? Not necessarily. Sometimes the two departments at a lender, REO and Short Sales, work against each other. A good real estate agent and a good Negotiator (more on this person later) can usually convince the lender that the short sale attempt is genuine and can get the foreclosure process delayed.
How long does it take? Aren’t the lenders fumbling and delaying? Not so much now. Earlier, there was little standardization between lenders. The process was complicated, bureaucratic, and took as long as 6-10 months. The federal HAFA program (Home Affordable Foreclosure Alternatives) was fully implemented in April of 2010 and its incentives and guidelines resulted in a simpler, faster and more consistent process among most lenders for all mortgages.
What are these HAFA and HAMP programs? These apply only to mortgages under $729,750 but most lenders have adopted the HAFA processing policies for mortgages of any size. The HAFA program addressed the numerous deficiencies of the preceding HAMP program (Home Affordable Modification Program). The February 2009 HAMP program asked lenders to provide troubled owners with loan “modifications” (reduced interest, reduced principal, reduced payments, etc.). As you can imagine, the lenders weren’t all that enthusiastic about it. Plus, the criterion was quite restrictive and many applicants could not qualify or, if qualified, were unable to comply with all the requirements. For those people, HAFA facilitates short sales through:
- Standardized paperwork, process, and timelines
- Prohibition of Deficiency Judgments (the unpaid part of the mortgage is forgiven)
- $3000 relocation assistance and $1500 to the loan servicer
Is HAFA a cure-all? While HAFA has helped a lot, the tribal customs of lenders are still a little weird. In addition, the process varies a lot in how it’s supposed to work versus how it actually works in the real world.
So, how does one get through the remaining red tape? Unless your real estate agent has considerable experience at short sales, it’s best to have them use a licensed Short Sale Negotiator. Properly experienced Realtors and licensed negotiators are experts that know the process thoroughly, how it really works, the state and federal regulations and programs, the variances between lenders, the lenders/servicers contacts and how to work them, and how to best package, present, and negotiate the deal to avoid a months-long process (note that a months-long process often results in buyers losing patience and canceling offers).
What exactly is the process? The Realtor lists and markets the home with a price based on a Competitive Market Analysis (CMA) of local comparable sales (some lenders will pre-approve a short sale price). When a purchase offer acceptable to the owner is received, it gets submitted to the lender along with a Short Sale package (some lenders will also accept subsequent offers).
What’s in the “short sale package”?
The most common reason for delays and rejections is an improperly prepared package (all the more reason to use a Negotiator). A typical package includes:
- Two years 1040 tax returns
- Two months pay stubs (or a P&L if self-employed)
- Two months bank statements
- Financial statement (form provided by lender)
- Hardship letter
- The CMA of comparable sales within the past 3 months (some lenders allow 6 months)
- A Broker’s Price Opinion (BPO) is also required by some lenders
- The Purchase Offer and associated real estate forms
What does the lender do with the package? The lender examines the package for completeness. If it passes this test, a manager is assigned to evaluate the content and to handle the subsequent negotiations and approval process. Final approvals take several weeks with a Negotiator…but can take months without one. If everything gets done right, the owner walks away free and clear.
What about Deficiency Judgments? Protection varies from state to state. California provides much more protection to the short seller than other states and the federal rules. California Civil Code Section 580(e) went into effect January 1, 2011. It provided that "[no] judgment shall be rendered for any deficiency under a note secured by a first deed of trust or first mortgage for a dwelling of not more than four units." It solidified a California short seller’s protection from a lender going after the unpaid balance of a first deed of trust. Most lenders already did not but, prior to this without a documented "Account Satisfied", they could have.
A subsequent bill, SB 458, passed in July of 2011 and closed the few loopholes in Section 580(e). It limits lenders' demands in connection with short sales by effectively treating a short sale as if it is a non-judicial foreclosure sale. This is significant because it prohibits a lender from making additional demands on the seller.
SB 458 also expands Section 580(e) by covering primary and junior loans. As stated by C.A.R. President Beth Peerce, “SB 458 brings closure and certainty to the short sale process and ensures that once a lender has agreed to accept a short sale payment on a property, all lien holders – those in first position and in junior positions – will consider the outstanding balance as paid in full and the homeowner will not be held responsible for any additional payments on the property.”
It also prohibits holders of residential mortgage loans from requiring the borrower to pay any additional compensation, aside from the proceeds of the sale, in exchange for the lender's written consent to the sale. This means that a lender who agrees to a short sale may not require the borrower to either pay additional sums beyond the proceeds of the short sale, or sign a deficiency promissory note.
But there are two big exceptions that can nullify these protections:
1. If the seller commits fraud
2. If the seller “commits waste”.
Fraud can be misrepresentations in the original loan application or in the short sale process such as misrepresentations of hardship or concealment of additional offers.
Waste is a legal concept in which a party diminishes the value of the property such as removing appliances or anything else that was part of the home when purchased.
What about Federal Income Tax on the forgiven deficiency? The federal Mortgage Forgiveness Debt Relief Act of 2007 applies to primary residences only and covers the 2007 through 2012 tax years. Taxpayers may be able to exclude up to $1 million ($2 million if married and filing joint) if eligible (eligibility info is in IRS Pub 4681; it can be downloaded at www.irs.com). If eligible, the taxpayer files a Form 982 with their return in the year the deficiency was forgiven. A qualified professional should be consulted on this matter as there are exceptions.
What about State Income Tax on the forgiven deficiency? It varies considerably from state to state. In California, the Conformity Act of 2010 forgives the tax within limitations. In general, effective for taxable years 2009 through 2012, the maximum qualified principal residence indebtedness eligible for relief is $800,000 for taxpayers who file joint returns, single persons, head of household and qualifying widow or widower. For married or registered domestic partners taxpayers who file separate returns the limit is $400,000 each. A qualified professional should be consulted on this matter as there are exceptions.
What’s the credit impact of a short sale? Credit companies cannot definitively state how much delinquencies will affect scores because there are simply too many variables. Some borrowers will fall much more steeply than others for the same payment problem, according to Maxine Sweet, vice president for public education at Experian, one of the nation's main credit bureaus. FICO scores range from 300 to 850 and people with very high credit scores lose more than low-score borrowers because those low scores have already been impacted by credit problems.
The effect of a delinquency can only be expressed as a wide range due to the many variables including the starting score:
- 30 days late: 40 - 110 points
- 90 days late: 70 - 135 points
- Foreclosure, short sale or deed-in-lieu: 85 - 160
- Bankruptcy: 130 - 24
You can see Fair Isaac's charts at Banking Analytics Blog (bankinganalyticsblog.fico.com) under “Research looks at how mortgage delinquencies affect scores.”
Even if borrowers made payments faithfully for years before short selling or doing a deed-in-lieu, their credit score will still take a hit. The total decline will run about 85 points for the low 680 score borrower to as much as 160 for the high 780 score. The negative impact of a short sale can be slightly less if the lender does not report a “Score Factor Code 22” (it includes delinquencies, derogatory records and collections). Experian's Sweet recommends that people with a troubled mortgage should cut their losses quickly. "You need to do what you need to do to get your finances back in order," she said. "Don't worry about your credit score."
How long before the score recovers? While a short sale will negatively impact your credit score, it won't last long. People with previously good credit will see their scores begin to improve as soon as the house is sold. Predictions from various sources of “how fast” vary widely from 1 – 2 years to 4 – 7 years (of course, predictions from lenders tend to be discouragingly long). A Realtor with considerable short sale experience is the best source for the actual patterns in the local area. Good credit behavior will gradually supplant bad credit even though the derogatory will remain for 7 years.
How long before buying another home?
Foreclosure: It takes two to seven years before a loan application will be accepted. It all depends upon the lender and where they sell the loan. Wall Street, Fannie and Freddie all have different guidelines for loans they will accept and the criteria for what they determine to be a “qualified borrower”. And FHA, who insures 30% of new loans, requires a 3 year wait before they will insure a loan for a previously foreclosed borrower. The VA requires 2 years. Fannie and Freddie are the longest at 7 years. However, there are potential exceptions for extenuating circumstances such as job loss, big medical bills, divorce, etc. Depending upon the case, Fannie may reduce the wait to 3 years and FHA may waive as much as their entire 3 years.
Short Sale: The good news for short sale sellers is the wait is often much shorter and, in some cases, is waived entirely. FHA, for example, will waive their 3 year wait if the mortgage payments were made during the 12 months preceding the short sale. The size of the down payment can also shorten the wait, e.g., Fannie will reduce their 7 year wait to 2 years with a 20% down and to 4 years for a 10% down. For nonconforming loans, credit expert Linda Ferrari says major lenders typically require a wait of 24 months before an application will be accepted.
In all cases, if the credit history has been good since the short sale, the interest rate should be reasonable. Even though the derogatory will remain for 7 years, good credit behavior does ultimately supplant bad credit.
For a lot more information on Short Sales, go to the web site sponsored by the California Association of Realtors at http://www.shortsalescalifornia.org/
See also, on this site:
- "Foreclosure" tab for the explanation of:
- State Differences - Judicial versus Non-Judicial Foreclosure
- California Timeline
- Strategic Foreclosure
- "Mortgage Info" tab for the explanation of:
- HAMP and HAFA programs
- Mortgage versus Trust Deeds
Note: All the information contained herein is correct to the best of our knowledge and is freely provided with that caveat. A real estate agent and a Negotiator can provide professional advice within the scope of standard real estate forms and their respective practices. However, they are usually neither lawyers nor accountants, nor are we. It is recommended that a tax attorney be consulted for legal and tax considerations, especially if the situation involves anything other than an original mortgage on a primary home.