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What is a short sale?

Put succinctly, a short sale is when a house is sold for less than what the homeowner owes on it, and the lender does not get all of its money back. A short sale occurs only with the lender’s permission.

Why a short sale can be beneficial

A short sale occurs when a home’s value has declined and the mortgage holder owes more than the home is worth. The homeowner not only has no equity, but in fact has negative equity.

Sometimes the borrower misses making mortgage payments for three to six months and is served with a notice of default. To prevent foreclosure, the borrower can try to settle the debt with the lender through a short sale. Other times the borrower doesn’t miss payments but cannot endure the burden of making payments on a home that has lost its value.

An interested buyer typically makes an offer in line with property values, but the seller is not in a position to accept the offer. The seller’s lender must approve the offer since it is being asked to accept a lesser amount than the total it is owed. In this situation, sellers complete an application seeking short sale status and write a hardship letter to the lender indicating they cannot repay the difference between the prospective buyer’s offer and the amount owed on the mortgage. This is backed by proof, such as tax returns and pay stubs.

If an appraisal of the home closely matches the buyer’s offer, the lender may accept it, though the process can take months. To stem its losses, the lender often insists the buyer pay for any repairs and closing costs which are normally paid for by the seller.

Once a short sale transaction closes, the debt is settled and the seller is off the hook for the difference. A short sale has less of an impact on the seller’s credit score than a foreclosure. All parties can potentially walk away satisfied with the deal.

How a short sale can go wrong

From a buyer’s perspective, buying a foreclosure or short-sale home might hold the promise of a great deal, but it’s important to be aware of expenses that can arise after the purchase.

Just ask Adam Melson of Philadelphia. Melson had looked at more than two dozen houses before he decided to buy what looked like a great deal: a short sale in a good neighborhood. But after spending $40,000 on renovations, he learned his “deal” had hidden costs.

Melson’s home inspector had said the short-sale house was fine; there was just a little termite damage in the basement. But when Melson tore up the linoleum to repair a soft spot in the kitchen floor, he found that the damage went much deeper.

5 common mistakes of short-sale buyers

  1. Ignoring property problems.
  2. Skipping the home inspection.
  3. Ignoring legal and insurance information.
  4. Leaving too little time for closing.
  5. Falling hard for a bad home.

“The boards supporting the kitchen floor were entirely eaten by termites,” he says. “I also learned at this time that the kitchen sink did not drain anywhere. It drained openly under the house.”

Melson ended up replacing an entire wall of his house. That was before the roof started leaking and he discovered thick, smelly mold behind the shower stall. “With several other things I wasn’t expecting, I wound up hauling over 10,000 pounds of my house to the dump in rented box trucks,” he says.

Know what you’re getting into before you buy a short sale or foreclosure property, and be mindful of these five common mistakes.

1. Ignoring property problems

Some homeowners who face foreclosure become angry and take their anger out on the house they’re about to lose.

“They’ll often take that frustration out on the property,” says Jason Scott Steinhorn, a Maryland real estate investor with experience in foreclosures and short sales.

“I’ve seen a couple of foreclosure properties where the previous owners clearly took a sledgehammer to the nice hardwood floors, the tiled showers and the cabinets, just to be spiteful,” he says.

Vacated houses in foreclosure may sit empty for months or years before they’re purchased. As a result, problems arise, such as leaks, mold, termites, filth, thieves and squatters.

There are a couple of little-known loan programs, the FHA 203(k) and Fannie Mae HomeStyle, which offer solutions for homebuyers who want to renovate.

2. Skipping the home inspection

Tag along when your home inspector shows up. You might be surprised what you can learn.

Kathleen Kuhn, president of New Jersey-based HouseMaster, one of the largest home-inspection franchises in North America, says, “Most of what we do is education.”

  • Ask for repair estimates when an inspector notes a problem, or do some research of your own later. “Every homeowner underestimates how much renovation costs,” Kuhn says.
  • You may want to call in specialized inspectors to look for expensive problems such as termites, mold and structural damage, particularly if it’s a common problem in your area.
  • Make sure to hire an inspector that’s highly rated. Ask for recommendations from friends, or weigh online user reviews heavily. Just as with any other industry, there are excellent, marginal and bad inspectors.
  • You are allowed a certain window of time to inspect the home, known as an inspection period. Shortening an inspection period may give you leverage in a regular real estate situation when you’re placing a bid, but don’t skimp on or skip the inspection period when you’re about to buy a foreclosed or short-sale home. Use this time to make a decision.

3. Ignoring legal and insurance information

A typical disclosure statement would indicate whether a house is in a flood plain or had any unpermitted renovation, Steinhorn says. But bank-owned properties often sell as is, without disclosure, so buyers need to do extra research on the home.

Ensure that all renovations have been permitted and approved. “If not, and there is a problem, the city can cite you,” says Brendon DeSimone, who manages two luxury real estate offices in New York’s Westchester County.

4. Leaving too little time for closing

Short sale and foreclosure homebuyers need to be aware that the sale won’t necessarily close as quickly as it would for a regular home purchase. The short seller’s lender must approve the foreclosure terms or short-sale price, which will be less than what the seller owes. Even so, banks may be slow to respond.

“They aren’t just going to let the house go,” DeSimone says.

It’s not always possible or even desirable to get a home loan from the bank that has a mortgage on the short sale you’re buying. In fact, it’s best if you show the lender a preapproval letter that you obtained from your own lender within the last 30 days.

5. Falling hard for a bad home

Don’t assume you’re getting a great deal, says Connecticut real estate investor Jim Randel, author of “The Skinny on the Housing Crisis.”

“Think of yourself as an investor,” he says. Objectively consider the house’s condition, inspection, price and value.

Randel suggests that you ask yourself these common-sense questions:

  • If you were to buy this property, could you afford to rent it out for as much as, or less than, your mortgage payment? Use Bankrate’s calculator to estimate your mortgage payment.
  • If the home’s value drops 20 percent, will you still feel satisfied with your purchase?
  • How much money will you have to spend on the property to make it habitable?

Kuhn says that sometimes HouseMaster inspectors have bad news for prospective buyers, but some homebuyers just won’t listen. She says buyers declare, “This is our house and we love this house,” despite a broken sewer line, rats in the basement or a collapsed roof.

As long as you fully understand how foreclosures and short sales work, nothing should stop you from getting a good deal and finding the house of your dreams. Just be sure to carefully consider the home inspector’s advice and report before making your decision.