If you are one of the many homeowners who have fallen behind on your mortgage payments and you don’t see any way to avoid foreclosure, a short sale may offer you the least painful way to resolve the situation.

A short sale is when a lender agrees to accept a mortgage payoff amount less than what is owed in order to facilitate a sale of the home by a financially distressed owner. The lender forgives the remaining balance of the loan.

What’s in it for a seller?

Obviously, the ideal scenario would be that you magically catch up on your mortgage payments and keep your home. But for an increasing number of Americans, that is not a realistic possibility, so it’s to your advantage to take an active role. This is what a short sale is all about — resolving the problem, as opposed to simply hiding from your lender and hoping the issue will go away or, worse, walking away from the property.

As a seller, there are cons to a short sale. Obviously, you will lose your home — but that will happen anyway when the bank forecloses. You will also walk away without a cent in profit from the sale. And, your credit score will take a major hit.

However, because you are making a good faith effort, the lender may look more favorably on you, and perhaps be willing to help minimize the damage to your credit score. You are also spared the stress and embarrassment of a long drawn-out foreclosure process. That’s may allow you to feel more in control and that you have a more direct role in paying off part of the debt. Remember, too, that every short sale is a negotiated agreement between the owner and the lender. In a foreclosure, the lender can always pursue the seller for a deficiency judgment to recoup the difference between what it was owed and what it actually collected. In a short sale you may be able to get the lender to accept the sale as “payment in full without pursuit of any deficiency judgment.” The lender might agree to that release in return for the seller showing the home, maintaining it as well as possible and not trashing it on the way out.

Two short-sale killers

Before you even start considering getting involved in a short sale, there are two situations in which an attempt at a short sale is almost certain to fail.

An attempt at a short sale will fail if:
  • No default on loan — Lenders almost never will accept short sale offers or requests for short sales until the borrower is far behind in payments and a notice of default has been issued.
  • Bankruptcy — If the seller has filed for bankruptcy, forget it. Few, if any, lenders will consider a short sale when the seller has filed for bankruptcy, because negotiating a short sale is considered a collection activity and collection activities are prohibited in bankruptcies.

The lender’s motivation

Why would your lender let you walk away from the home and forgive the shortfall on your loan? To save time and money. Foreclosures are expensive and time-consuming for lenders. Once the lender realizes that a foreclosure is inevitable, a short sale may seem like the lesser of two evils. Plus, short sales help the lender look good on paper — the property was never listed as an actual foreclosure, which helps the lender’s numbers.

In a January survey of senior loan officers conducted by the Federal Reserve Board, more than 65 percent of those surveyed said they anticipate steps such as short sales or deed-in-lieu of foreclosures to be at least somewhat significant loss-mitigation steps at their banks for 2008.

Convincing the lender

There’s no guarantee, but if you have evidence to back you up, a lender may agree to a short sale.

But don’t think it’s going to be easy. It’s going to take a lot of proof and convincing evidence. To make your case, you, the buyer and any agents should work together to assemble the following package.

1. An authorization letter. You have to sign this — and usually have it notarized — giving the lender permission to discuss the mortgage situation with a potential buyer or an agent.

2. A hardship letter. You have to show that your financial situation is desperate. You’ll have to be 60 to 90 days behind in your payments and have no significant cash, savings, retirement plans, stocks, bonds, cars, boats, vacation homes, time shares, jewelry, etc., that you can use to catch up or reduce your debt. And you will have to show the situation is irreversible — that you will have no way to bring your mortgage current in the foreseeable future. You should supply as much evidence and documentation as possible, such as divorce papers, evidence of job loss, delinquent accounts, utility shut-off notices, car repossession paperwork, your last two years’ tax returns, recent pay stubs and recent bank statements. Include any mitigating circumstances, such as medical problems or the loss of a job. The more convincing and sympathetic — yet truthful — the letter is, the more likely your lender will agree.

3. A statement of the property’s value. This can be an appraisal or a broker’s price opinion. The lower the estimate of the property’s current market value, the better it will be for you. You want to show the lender it will not be able to sell the home for enough to satisfy the loan. It may not be pleasant, but you should make the home look as bad as possible on paper. Include things such as abundance of homes on your street or neighborhood for sale — especially in foreclosure. Other pertinent information to include is the number of rundown or unkempt homes nearby, increasing crime rate, high taxes and insurance rates, and low-rated schools. Prepare a written summary of your property’s condition, including a thorough and detailed list of any negatives, such as maintenance problems and evidence of disrepair. This can be tough emotionally. This is, after all, your family home, but this is a necessary part of the process. The longer a lender must hold onto a property the more expensive it becomes. If the lender realizes the property will bring them nothing but headaches, it will be more likely to OK a short sale. Richard Geller, developer of MortgageReliefFormula.com, says, “It’s critical to come in with the lowest — yet sound and ethical — valuation possible. If you can get a really low BPO and put that in your offer y9ou have a much better chance.”

4. A purchase offer or contract. It’s a bird-in-the-hand issue for the lender. A signed contract with a sizable earnest money deposit at a specified price can look far better to the lender than a long foreclosure process, ongoing costs and no guarantee at the end of the road. What’s more, lenders will not entertain tentative offers. You’re not going to get the chance to ask the bank, “If I could find someone willing to pay X number of dollars, would you approve a short sale?” “Remember, Geller says, “listings and pending sales and last year’s sales are meaningless. It’s all about what willing buyers pay willing sellers. If there has been no actual sales volume, there are no comparables, so there is a lot of room for a low BPO when the sales that have occurred were forced, foreclosure sales and everything’s for sale but nothing is selling.”

5. A settlement statement. To go along with the proposed price, this statement — also called a net sheet — details exactly how much the lender will end up with and exactly how much of a loss it will be taking. It includes the purchase price, the closing costs and any other costs or fees involved in the transfer of the property. You can get this prepared by the closing agent or real estate lawyer.

Finding a buyer

Before you even thought about a short sale, you probably had your home on the market, hoping to sell it for even a small profit, pay off the mortgage and stave off foreclosure.

But that hasn’t worked — possibly because you’re “upside down” — you owe more than the house is actually worth today.

While you may now be desperate enough to go for a short sale, you’re still seeking the same thing — a buyer. Some homeowners would like to get a tentative OK from the lender before seeking a buyer, but this doesn’t happen in most cases — the lender won’t tell you it will accept any less than what it is owed and also probably won’t even discuss this until you’re 60 or 90 days behind in your payments. Any lender is more likely to agree if a buyer is already in place and you have a legitimate, signed offer with a sizable deposit.

There are a few things you can do to find a buyer. You can go the “For sale by owner” route with a sign on your lawn and classified ads locally and online. Explain to anyone that responds that you are seeking a short sale arrangement.

Consider, however, a short sale is not a do-it-yourself project, and this is one time you should seriously consider getting a real estate agent who has a track record with short sales, foreclosures and bank-owned properties. Real estate agents often maintain a contact list of investors and buyers in the area. Ideally, you will want to find a buyer who has at least a basic familiarity with short sales or works with a broker who does.

In addition to writing up the hardship letter and documenting the property’s shortcomings, you should do everything else in your power to help convince the lender that the property would be difficult to sell via normal channels. Gather up any repair receipts and/or estimates. Take pictures (or allow the buyer to do so) of any problems or defects. Allow the buyer and their broker/appraiser to access the property (inside and out) when necessary.

Important details

  • In some cases, the lender may send you a 1099 tax form, which will list the “shortfall” (the amount the lender has forgiven) as income to the seller. Don’t be alarmed: The Mortgage Forgiveness Debt Relief Act of 2007 gave short sellers a big tax break by changing the way the forgiven amount was viewed for tax purposes. Prior to passage of the act, that amount was considered as income for the borrower and was subject to tax. However, the new law removed that tax liability.
  • If you have more than one mortgage or more than one lender, remember they all have to approve the short sale. Make sure your sales contract includes all lenders’ approval in writing. Lenders holding second or third mortgages probably will get nothing if the property is foreclosed, so at least in a short sale they have a chance of recouping some of their investment.
  • Some states allow deficiency judgments, in which a lender can pursue the borrower for any remaining balance of the loan. This usually only applies to cases where the home is sold at auction or as an REO, a real estate owned property, by the lender. In a typical short sale agreement, the lender agrees to waive this right. Make certain you’re protected from this in the short-sale agreement.

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