One thing we’ve heard a lot about the last couple of years is the rash of foreclosures and short sales, and how the real estate market is experiencing a huge downturn. A lot of people are finding themselves underwater in their homes, owing more on the homes than they’re currently worth. People have seen their home values drop by tens of thousands of dollars, if not hundreds of thousands.
In the area that we live in the story hasn’t been much different. There have been a lot of foreclosures and home values have dropped significantly. We bought our house near the height of the housing bubble, and over the past 5-6 years we’ve watched as our home value has dropped by more than $70-80,000 dollars. I don’t have to tell you that it hurts to watch your equity disappear into thin air like that.
Over the past year or so we’ve been thinking about upgrading our house a bit, in part because we’re hoping to have more children some day, and want to have more space, and a backyard for them to play in. We also figured now would be a pretty decent time to buy with the home values being so low. We’ve been able to find some properties that we’d like, and we’ve strongly been considering building our own home since my in-laws are builders.
Owing More Than Your Home Is Worth
Our only problem? Despite the fact that we’ve paid off almost $80,000 of our mortgage, we’re not sure we can sell our house for more than what we owe on the property. The values have just dropped too much. We’ve also looked at sales of similar homes, and they’re selling for an additional $30-40,000 less than we thought our home was worth.
My wife’s mom, while discussing the topic, suggested that the solution was to do a short sale, and then start over and buy a new house. I don’t think my mother-in-law or wife are aware of just how a short sale works, or that there are significant downsides to doing one.
How Does A Short Sale Work?
Just saying you’re going to do a short sale isn’t enough as not all lenders will accept a short sale or discounted payoff. In many cases for the lender it makes more financial sense to foreclose – and they’re under no obligation to agree to a short sale. Also, not all properties or sellers are eligible for a short sale.
To get the process started you would need to first call your lender and talk to the person responsible for handling short sales, and capable of making a decision. Next you’ll need to submit a variety of paperwork. The things often asked for include a preliminary look at the numbers (how much you’ll sell for, and how much the shortfall will be), a hardship letter explaining why you need to do a short sale, proof of income and assets, copies of bank statements, a comparative market analysis showing prices of similar homes in the market and when you finally find a buyer – a purchase agreement.
In other words you have to contact them and show them that there is a good reason for doing a short sale. You also have to show them that you are truly having a financial hardship. Then they will make a decision as to whether they’ll allow a short sale.
Luckily, if you’re considering doing a short sale, some banks are now even offering short sale incentives to some people to go through with a short sale instead of a foreclosure.
Should You Do A Short Sale?
So the question is, do you really want to do a short sale? Will your situation even qualify for a short sale?
Some reasons that may NOT qualify for a short sale:
- Wanting to buy another home: The lender won’t care if you want to move to a different location or bigger home.
- Pregnancy: Having the size of your family increase or expenses increase are not qualifying hardships.
- Spending all your money on electronics: Having irresponsible spending habits will not qualify you.
- Bad neighbors: You may have found that all your neighbors are drug dealers, but this won’t qualify you to do a short sale.
Some reasons that might qualify for a short sale:
- Unemployment: If you lose a job and your source of income, that may be a qualifying hardship.
- Bankruptcy: Having a bankruptcy could be a qualifying hardship since you probably don’t have the money to pay your mortgage.
- Death: Having one of the spouses die could qualify you.
- Divorce: Having a divorce and a resulting loss of dual incomes or other expenses could qualify you.
- Health problems: Having health problems that lead to financial hardship, that could qualify.
The point here is that you have to be able to show some legitimate source of financial hardship that precludes you from making full payment on your loan. So if you just want to get a bigger house with a nice fenced in yard, that is not a good reason to be doing a short sale.
Consequences Of Doing A Short Sale
So even if you qualify for a short sale, what are some of the consequences of going through with one? Will it put a blemish on your credit report? Is it better than walking away and going through foreclosure?
Here are some of the things to consider:
- Your credit will be dinged: If you decide to do a short sale your credit will be hurt. It will usually show on your report as a pre-foreclosure that has been redeemed, and reported as paid in full for less than agreed. While you might think that a short sale would be better than a foreclosure on your credit, many lenders will not make distinction and just see the fact that in both cases the bank probably suffered a loss. Both a foreclosure and short sale are reported and will affect your credit score about the same. From what I’ve read the ding to your credit score could be anywhere from 2-300 points. It could be slightly less on a short sale if you weren’t behind on payments.
- Tax or debt consequences: You may be liable for taxes on the forgiven mortgage debt. In some situations the bank will issue you a 1099 for the forgiven amount and you’ll be liable for taxes on that amount (which could be a huge tax bill). Also, in some states the bank may come after you for the amount you are short. Some states are no recourse states and you won’t have this issue, but others do not. Check the laws in your state.
- You may not be able to get another home loan: If you’ve had a foreclosure or short sale you may not be able to get another Fannie Mae or Freddie Mac backed loan. You’ll have to wait at least 2 years to get another loan with a short sale, and 5 years with a foreclosure.
So if you thought that there were advantages to a short sale over a foreclosure when it comes to preserving your credit, most sources that I’ve read say that really isn’t the case. They both affect your credit about equally. About the only advantage would be if you wanted to get a new home loan sooner, you may be able to get one within 2 years after doing a short sale. Beyond that, you may be liable for taxes on the forgiven debt, or in some cases liable for the difference itself. Make sure to do your homework before going down that road.
For us, we’re definitely not going to be going down the road of a short sale as we can afford to make the payments, we don’t have any hardship and I don’t want the ding to our credit. That plus we’d need to get another home loan right away if we sold. So I guess we’ll just have to wait until we can sell it for what we need, or save up the difference.
Have you considered doing a short sale, or going into foreclosure? After knowing the consequences, would you still attempt to do one?
Jeffrey Trull says
Nice explanation, and you’re dead-on from what I know based on working with foreclosures. Unfortunately, short sales are not a cure-all for our real estate problems, including being underwater on a mortgage. Someone in your position is probably stuck paying off the balance of the mortgage if you sell, and that would probably wipe out a lot of the benefit of taking advantage of this housing market.
Tyler S. says
I wasn’t aware of all the possible consequences of going for a short sale either, did you get your mother-in-law to read this?
Peter Anderson says
Hah.. No, I didn’t get her to read this, I just mentioned to her that there were serious consequences to your credit and ability to get a new home loan if you went through with a short sale. They haven’t brought it up since. I think it’s one of those things where they hear of someone else doing a short sale without knowing the details or what the ramifications are, and so they latch onto it. I think they’re aware now that it isn’t a good idea for our situation. :)
Great summary Pete. The short sale qualification process is being made a bit easier by the GSE’s (Fannie/Freddie), which I think will expedite the process. But there is no doubt the financial consequences – particularly to your credit – will be tough.
Also, be careful of telling your M-I-L she was a “uninformed” :)
Many people do not even understand how a mortgage works, much less a short sale or foreclosure. Many homeowners opt for a short sale, or even a deed-in-lieu, because the bank is coming after them via foreclosure. They want to be able to get another loan in 2 years versus 5 years on a foreclosure.
Ginger @ Girls Just Wanna Have Funds says
This is good information. The credit being dinged is one of the biggest reasons I won’t go through with a short sale but to be honest as long as we have tenants we’re fine. Once that becomes an issue then I will consider a short sale.
Short sales do not ding your credit as harshly as you state. The average ding VIA short sale is around 80-100 points. The sucessful short sale eliminates late pays and replaces them with “settled for less than full amount.” The tax problems are also null and void if it is a primary residence, as federal law doesn’t allow the IRS to collect taxes on the deficiency up until the end of 2012. This law was signed by GW Bush in 2007. Always find an experience short sale agent that will eliminate the possibility of deficiency judgements through contract stipulations with the lender.
Be carefull the law Bush signed is not mandatory and varies from state to State. Mass. is one who does not comply. We owed 10,000 after our short sale.
maryann brodeur says
Ty for the info. We thought once our kids were older we could downsize but no chance of that when the house next to us sold for less than half of what we owe after a forcloser. This just seems so unfair but we would not qualify for shortsale according to this article and we would damage our good credit is we forclose so I guess we stay and hope this turns around some day. Ty for this article.
I recently short sale(d) my home last June. I can tell you the process is dreadful, to say the least. I did not have a true ‘financial’ hardship either. My credit took a hit of 134 points. We are currently renting and will do so until we can buy. It is not a good experience but I feel it was the best for us and will have to deal the consequences and future consequences that
may arise in the future.
Lawyer Don says
Another factor to remember is that the temporary tax break which excludes the amount of debt forgiven in a short sale from taxable income based upon “forgiveness of debt” is set to expire at the end of this year (2012). Mr. Anderson makes many important points. Consider all of your alternatives and the implications of each. For many people, the credit scoring implications will be greatly outweighed by the tax consequences and effect of moving upon schools if you have school age children.
Interesting how nearly all brokers market the effect of a short sale as non existent. However fico states the contrary (precisely the same hit like a foreclosure).
Heres a good credit impact break down on this site http://practicallist.com/real-estate-short-sale together with fico and also fannie mae details.
Great article, what are your thoughts on whether on not it is biblical to do a short sale.