Buying a short-sale house: A guide to the process

14 min read

Short sales are far less common in the U.S. housing market today than a decade ago. The peak years for short sales were 2008 to 2012, during the mortgage crisis.

When a lender agrees to accept a mortgage payoff amount less than what is owed in order to facilitate a sale of the property by a financially distressed owner, it’s called a short sale. The lender forgives the remaining balance of the loan. Buying a home through a short sale is different from buying a property at a foreclosure auction, or one that is actually owned by the bank, known as an REO, or real-estate owned property.

A short-sale can yield a good deal on a property, but it generally takes a certain amount of fortitude and patience, plus a lot of luck.

In a short sale, everyone wins or nobody wins

Short sales are a mixed bag for the buyer, the seller and the lender.

If you’re a seller, a short sale is likely to damage your credit — but not as badly as a foreclosure. You’ll also walk away from your home without a penny from the deal, making it difficult for you to find another place to live. However, a short sale can forestall a foreclosure, and its negative impact on your credit. A short sale is less damaging than a foreclosure as long as the homeowner can persuade the lender to report the debt to credit bureaus as “paid in full.”

The buyer gets the property at a reduced price, but the property in all likelihood has its share of problems — think fixer-upper — and the deal need to go through considerable red tape to make it happen.

The lender takes a financial loss, but perhaps not as large a loss as it might if it foreclosed on the property.

In a short sale, the proceeds from the transaction are less than the amount the seller needs to pay the mortgage debt and the costs of selling. For this deal to close, everyone who is owed money must agree to take less — or possibly no money at all. That makes short sales complex transactions that move slowly and often fall through.

What is a short sale?

A short sale is when a house is sold for less than what the homeowner owes on it, and the lender or lenders don’t get all their money back.

A short sale occurs only with the lender’s permission 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.

Why a short sale can be beneficial

If a 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 impact on the seller’s credit score than a foreclosure.

Steps to buying a house through the short sale process

A typical short sale involves a series of steps, generally in this order, according to Bobbi Dempsey, co-author of “The Complete Idiot’s Guide to Buying Foreclosures.”

  1. Identify potential short sales.
  2. View the property.
  3. Do your research.
  4. Find all liens and mortgages.
  5. Figure out the financing.
  6. Contact the lender.
  7. Complete the lender’s short sale application.
  8. Assemble the proposal.
  9. Negotiate the terms.
  10. Seal the deal.

1. Identify potential short sales.

Locate preforeclosures in your area by checking online listings, searching courthouse listings, legal ads or using an experienced buyer’s agent.

First, try to determine how much is owed on the house in relation to its approximate value. If it seems high, it’s a good candidate because it indicates the seller might have trouble selling it for enough to satisfy the loan. Pass on those in which the owner has a lot of equity in the home — the lender likely will prefer to foreclose and resell closer to the market price.

2. View the property

Gauge its condition and come up with a rough estimate of how much it’s going to take to repair or renovate. If it needs work, many “normal” buyers won’t consider it, which is good for you.

3. Do your research

What is the property worth? What’s the profit potential? If you’re an investor or even a homeowner planning to live in the home a short time, you’ll want to profit from the deal.

4. Find all liens and mortgages

Ask the seller or his agent what liens are on the property, and which lender is the primary lien holder.

You’ll want to confirm this information through a title search before closing the deal, to make sure there are no undisclosed liens on the property.

5. Figure out the financing

This is critical. You have to know how you’re going to pay for the property. If you’re a good credit risk, the existing lender may be willing to give you a loan. Since they already have a lot of your information in the short-sale paperwork, they may be able to expedite the loan application process. It’s important to understand that in a short sale you have to have the ability to move quickly. Once an agreement is worked out, it is common the lender will require closing in as few as 20 days. This is too late to start shopping for a mortgage.

6. Contact the lender

You or your agent should speak with the loss mitigation department — or perhaps the resource recovery department — rather than the collection or customer service department, which is only interested in recouping past due loan payments. Finding the decision-maker can be one of the biggest initial challenges. You will first need to have the homeowner complete and sign (notarization is usually required) an authorization letter, which gives the lender permission to discuss the mortgage situation with you.

7. Complete the lender’s short sale application, if they have one

Many lenders have an application specifically for a short sale request. If they don’t find out what paperwork they need to consider a short sale.

8. Assemble the proposal

The proposal generally consists of a package of materials including the application and authorization letter, plus:

  • The purchase and sale contract — signed by you and the seller — to buy the property for a specified price. The lender is not going to entertain tentative offers. You’re not going to get the chance to ask the bank, “Would you take X number of dollars?” In most cases, this also means posting a sizable amount of money to demonstrate your desire and ability to go through with the transaction if it is accepted. If you can’t make a sizable down payment, the lender would have no reason to believe you can do any better than the last owner. It’s also important to the buyer that the contract be contingent upon all lenders approving the short sale in writing.
  • A hardship letter. It’s important to remember a lender will not even discuss a short sale until the homeowner has fallen behind on payments — usually 90 days. The lender must be convinced taking a smaller loss now is better than a bigger loss later. To make that case, start with a letter written by the seller giving an overview of the seller’s desperate situation. The lender must recognize the seller’s inability to pay the loan — immediately and in the foreseeable future — and that the situation is irreversible. The seller 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, last two years’ tax returns, recent pay stubs and recent bank statements. If the lender thinks the seller has money or assets stashed away, it won’t go along with a short sale.
  • 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 that the seller would not be able to get enough for the home via a normal sale to satisfy the loan. Compile a list of all the negatives and problems of the home that negatively affect the value and make it undesirable to the average buyer and tougher for the lender to resell. 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 approve a short sale.
  • Detail the costs and liabilities. You want to show the lender it would be much better off letting you take the property off its hands. If you can convince the lender the home is a money pit, all the better. Take photos of any damages and get estimates of the repair costs. Note: This is also a good opportunity for you to take an honest look at the property, and decide if you are willing and able to invest the time and money required to fix it up. Remember: A short sale is always an as-is sale.
    A settlement statement. This statement (which can be prepared by a closing agent or real estate lawyer) outlines the purchase price, the closing costs and any other costs or fees involved in the transfer of the property. Often referred to as a net sheet and the information can be entered onto a HUD-1 Settlement Statement to show the final, negative result at closing.

9. Negotiate the terms.

It’s not uncommon for the lender to reject your offer or to come back with a counteroffer. As with any real estate transaction, you should figure out beforehand what your absolute highest limit is, and don’t be afraid to walk away if the lender won’t meet your figure.

10. Seal the deal

Once you’ve reached an agreement that all three parties — you, the seller and the lender — are OK with, get everything in writing and officially recorded. Make sure the seller understands all of the terms of the deal. Next comes the closing and the property is yours.

The advice below comes from Scott Thompson, senior vice president of Mortgage Resolution Services, a distressed sales consulting company, and Vicki Vidal, associate vice president of government affairs for the Mortgage Bankers Association.

Know what you are getting into. Under the best circumstances, short sales take a long time to close and may require extra effort on the part of the buyer. Walking blindly into a short sale can be a losing and distressing proposition, so push for disclosure before you get involved, Thompson says.

Find a real estate agent with short-sale experience

A short sale is one real estate deal where you really need to get help from an experienced agent or attorney. Not all real estate agents know how to handle a short sale, so make sure you consult with one who can demonstrate special training or a good track record with short sales.

Find a real estate professional who understands the territory. Having a real estate agent on your side who knows how short sales work and who has negotiated others will increase the chances of closing the deal.

“I would ask the agent to provide references, specifically on an REO or a property that was in short sale,” Thompson says. “You certainly don’t want someone who is a shrinking violet.”

Get a property inspection

If the seller is in financial distress, chances are the home may not be well-preserved. The seller also may be reluctant to reveal serious maintenance issues. Proceed cautiously and get the property inspected by a knowledgeable person before you commit.

Improve your chances of closing the deal

Have your real estate agent talk to the real estate agent representing the seller and determine the status of the short sale. Below are items that most lenders require from a short seller. If the seller is unable or unwilling to provide this information, the short sale won’t close and any buyer is wasting his or her time. Your real estate agent should push for candor from the seller’s agent.

  • A hardship letter. The seller must explain why he or she cannot continue making payments. The sadder the story, the better. A seller who is simply tired of struggling probably won’t be approved, but a seller with cancer, no job and an empty bank account may.
  • Proof of income and assets. If the seller has money in the bank, including retirement funds, it is unlikely that the lender will let the debt slide. This package of information must include income tax and bank statements, going back at least two years. Sometimes sellers are unwilling to produce these documents because they conflict with information on the original loan application, which may have been fudged. If that’s the case, this deal is unlikely to close.
  • Comparative market analysis. This document shows that the price of the property has declined and that the property won’t sell anytime soon for the amount owed. This packet of information should include a list of comparable properties on the market and a list of properties that have sold in the past six months or have been on the market in that time frame and are about to close. This packet of information is similar to what’s known as a Broker Price Opinion, which is less formal but often more informative than a property appraisal. The prices should support the seller’s contention that the property is worth no more than the short-sale price.
  • A list of liens. There may be more than one, so determine how many liens are on the property. The good news is that since late 2008, the IRS has been willing to release a federal tax lien. The IRS is not forgiving the back taxes that homeowners owe; it is just no longer requiring that the lien be paid off before the property can be sold. And a single mortgage lien is an easy problem to solve.

Additional considerations

If there are first and second mortgage liens, the question becomes: What’s the plan to satisfy these lien holders? The seller and the real estate agent should have a plan that is more sophisticated than crossing their fingers, Thompson says. In the best of all possible worlds, the seller will be willing to contribute to paying off the second lien, so the first lien holder gets the full amount from the sale.

If there is a third mortgage lien, reaching any deal is very iffy. Deal killers include child support liens, state tax liens and homeowners association liens. If they exist and there are no obvious solutions, walk away, Thompson says.

Here’s another potential deal killer, something that can be difficult to sleuth out, says Thompson. Because a short sale generally doesn’t cover the whole amount owed or other liens, it can trigger mortgage insurance. If the property is covered by a mortgage insurance policy that doesn’t have to pay off until the home has been in foreclosure for 150 days or some similar length of time, chances are the insurer will hold up the sale because it won’t want to pay any earlier than necessary and hopes the foreclosure will just disappear. Often the mortgage insurer will simply go silent. Thompson says: No response, no approval.

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.