You’re browsing through some homes, using whatever search tool you like (we recommend HomeSnap, by the way), and you see a house that looks like it could be bargain. It’s priced below other homes in the neighborhood, maybe significantly. Then you notice the sale type, and it says “Short Sale” or “Potential Short Sale.”
What does that mean?
In a short sale, the expected net proceeds of the sale of the home will fall short of the total debts secured by liens on the property. There can be many different types of liens, although they most often fall into the general categories of voluntary and involuntary.
A voluntary lien is typically a mortgage, where a buyer enters willingly into an agreement to borrow and repay funds for the purchase of a home. Involuntary liens tend to be a bit more troublesome as they are liens imposed on the property by another party, often by the government in the form of a tax lien or by a contractor or similar kind of company as a mechanic’s lien.
With a short sale, the homeowner realizes that the property cannot be sold for the amount owed to all lien holders. For whatever reason, the current homeowner needs to sell, but the sale won’t give them enough money to pay off all the debt.
It’s important to understand that a short sale can be accomplished only when the lien holder(s) agree to accept less than they are owed. But a short sale is usually a better alternative for both the homeowner and the lien holders than a foreclosure. Although the homeowner will take a credit score hit in either a short sale or a foreclosure, the hit is often less with a short sale as the owner acted proactively to sell short than to just allow the lender to reclaim the house.
Lenders and other lien holders, however, have to agree. It may be possible for even a junior lien holder to derail a short sale if that lender won’t allow a reduction in the payoff to release their lien. And if the homeowner was paying mortgage insurance on their loan, the insurance company may become yet another party to the short sale because the policy may be asked to pay out to offset the loss of some creditors. For these reasons, short sales can be extremely complex to negotiate.
Risks for Homebuyers
In addition to the complexity involved in buying a short sale, buyers should be aware of some other risks they may face when considering this type of sale. Deals that allow you to purchase below the appraised value are definitely not the norm, and there’s a reason why. So it’s important to go into a short sale with your eyes open.
It Can Takes Months or Longer
The “typical” home-buying process takes about 30 to 60 days from contract acceptance to closing. And to get to contract acceptance from your initial offer might involve a little back and forth, but that can usually be wrapped up in a few days.
Be prepared for a different experience with a short sale. Remember that all lien holders need to agree to a short sale? You’re not dealing with a standard transaction, where a seller and buyer can agree mutually on a purchase price, and as long as the house appraises for that price the sale can go through.
When you’re looking at a short sale listing you may notice it says “third-party approval” is required. That means that any and all lien holders will have to be consulted and approve the deal. You might think that arriving at a purchase price and moving forward with the sale would be in everyone’s best interest, but that doesn’t mean the process will move forward quickly. It’s not called a short sale because of the time involved.
Once you’ve arrived at a price between the seller and buyer, it can take another 2 to 6 to even 12 months or more for all parties involved to come to an agreement. In the meantime, you may miss out on other properties. If you’re not a patient person who is willing to live with uncertainty for the chance to save some money, a short sale may not be for you.
You're Buying As-Is
The seller is selling short, right? That means they are likely in some kind of financial distress. And that means they won’t have money to make repairs. And if they had the money to make repairs, the lien holders would prefer to be paid first. The lien holders won’t want to make repairs either. So although you may be entitled to have a home inspection (and you should definitely have a home inspection), any issues found will be on you, the buyer. The sellers also may reject an offer that has any kind of inspection contingency, so you will likely be forced to agree to an as-is clause.
More Upfront Costs
Often with a short sale the lien holders will want to see a larger deposit to help mitigate their risks. They are already losing some money on the deal, so they want to ensure it will go forward. Buyers may also be required to pay all transfer fees and taxes, whereas in a standard sale these costs are typically split between the buyer and seller. Finally, just because a buyer and seller agree on a purchase price doesn’t mean the lien holders will agree as well. They may insist on a higher price as it impacts their bottom line.
The Deal May Fall Apart
Even after months of waiting and negotiation, the lien holders may not be able to reach an agreement to allow the deal to go forward.
Another potential cause for cancelling the deal is a change in the buyer’s credit and income picture (debt to income ratio or DTI). Because short sales often take longer, there is a greater chance that events could cause a buyer’s DTI to change. Life happens. If you need to buy a new car or you lose your job, you may no longer qualify for the purchase price.
Or, once you receive third-party approval and you can finally have your home inspection(s), those inspections may reveal an issue that is too great or costly to overcome. Or the appraisal may occur and the lender may no longer approve the purchase as-is because of an issue with condition.
Tips for Homebuyers
Given all of the risks and challenges outlined above, you may wonder why you would ever consider purchasing a short sale. It’s definitely not for everyone. But if you have the right mindset and the ability to wait and you approach the process carefully, it can be rewarding. Here are a few pointers that can help make the process a little easier.
Only One Lien Holder
Your Realtor can do some research for you on any property to determine what liens may exist. Ideally you want to find only one mortgage to simplify the process significantly. With only one lender involved, negotiations are easier and typically faster.
Loan Pre-approval or Commitment
Not all lenders are the same and not all “pre-approvals” are the same. You may see some lenders issue a pre-qualification, which means they perhaps spoke with a buyer over the phone, asked a few questions, and based on those answers believe the buyer “should” be able to purchase the home. Pre-qualifications aren’t worth the paper they are printed on in a short sale.
At a minimum you want a full pre-approval and ideally a loan commitment. A pre-approval involves collecting documentation and running a buyer’s information through automated underwriting. A loan commitment goes even further, approving the purchase typically pending a successful appraisal.
Work with a lender experienced in short sales who is committed to a thorough vetting of your ability to purchase. Your offer will be viewed more positively by the other parties and you will be much more likely to make it to closing.
Make sure you do your homework before you put your offer together. Have your agent run the comps of active, pending, and sold homes in the area to accurately determine the home’s value. Sometime an inexperienced listing agent may list the home for many thousand below market value to try to get offers. There’s not much worse than writing a low-ball offer, waiting for months for third-party approval, and then finding out the lender wants a significantly higher purchase price.
Experienced Listing Agent and Negotiator
You may encounter short sales in many different stages. Sometimes the homeowner has just made the decision and has the property listed immediately. A good listing agent will make sure the homeowner has started the application process, but not all listing agents are experienced in short sales.
Ideally you want to find a short sale that is far along in the process, where an experience short sale negotiator has been involved and received an approved price for the sale from all parties. That’s the holy grail of short sales.
Buyer’s Agent Experienced in Short Sales
Just like you want an experienced lender, listing agent, and short sale negotiator, you also want to find a buyer’s agent who understands and also enjoys working on short sales. Your agent should be able to explain all the potential risks and rewards to help you reach a decision. The agent should also be able to coordinate with the listing agent to ensure that third-party approval is received as soon as possible. An inexperienced agent can sink the deal entirely.
Yes or No?
Clearly there are many things to consider when deciding whether to attempt a short sale purchase. You need the right temperament, and you need to be prepared for a much more complex process and a longer-than-usual path to closing. There is greater risk, but there can be greater reward.
How do you know if you’re a good candidate for a short sale? That’s tough to say, but here are a few situations that should cause you to seriously reconsider buying a short sale:
First-time homebuyers - this is not the experience you want for your first home-buying experience. Also, lenders are less likely to take the risk working with a first-time buyer in a short sale.
Renters - if your lease is up and your purchase hasn’t happened yet, you may need to go month to month (if you can) at a much higher monthly rent, or risk renewing and breaking your lease.
Low income/limited assets - if you are not financially stable, the potential financial issues that can occur in a short sale could be catastrophic.
If you have any questions about short sales or any other real estate-related topics, contact us.