You may have heard of people selling and buying short sales, but most people don’t really know what one is or how a short sale works. If your home is in jeopardy of foreclosure, you will want to look into the short sales options to see if this might be the most financially sensible route to pursue.

What is a Short Sale?

A short sale is the sale of a home for less than what is owed on the mortgage.

What Does a Short Sale Look Like?

Let’s say you bought your home for $225,000 and you still owe $200,000 on the mortgage, but home prices have fallen, and you’ve just gotten an offer on the house for $175,000. A short sale would ensue if the lender agrees to sanction the sale of the house for $175,000, which would be $25,000 short. (Not to mention the bank will have to negotiate how closing costs will be handled.) In a short sale, the lender waives the amount that is still owed on the mortgage, removes the lien, and everyone is free to move on.

How do Short Sales Come About?

Obviously, a short sale is not in the lender’s best interest. The following are examples of situations where a short sale may come about:

• A buyer offers less than what is due on the mortgage, and the lender determines that a short sale is the most profitable potential outcome
• A home goes into the pre-foreclosure stage, and the lender agrees with the seller that a short sale will be preferable to a foreclosure

How do You Approach Your Lender About a Short Sale?

You can’t just call up your lender and say, “I want to sell my house for less than I owe on it, and I expect you to be okay with that.” If you can’t make up the monetary difference (there is no rule against selling your home for less than what you owe if you can pay off the rest of the mortgage at the time of the sale), you’ll have to get lender approval of a short sale, and that is not always easy to do.

What Factors Constitute Qualifications for a Short Sale?

To qualify for a short sale, you must have most if not all of the following conditions in place:

• Your home value must have dropped below what you owe on the mortgage
• Your home is in pre-foreclosure status or will be at serious risk of foreclosure
• You can prove that you (as the seller) have experienced significant, unavoidable hardship that has affected your ability to pay the mortgage, forcing you to sell (such as divorce, death, extended unemployment, bankruptcy, debilitating illness, or injury)
• You have no assets to tap into (such as investments or savings)

What if Your Lender Agrees to Sanction a Short Sale, but the Buyer Falls Through?

If you can’t come up with a buyer, you’re stuck at square one. A short sale is contingent upon a buyer making and following through with an offer to buy the house at a price lower than the amount due on the loan.

How Will a Short Sale Affect Your Credit?

While the affect of a short sale won’t be as severe as the affect of a foreclosure on your credit score, it will still have a significant effect. Your short sale will be recorded on your credit history as something like: Redeemed Pre-foreclosure, Paid in Full for Less Than Agreed. This will pull down your credit rating, and it will affect future lenders as they weigh the risk of taking you on as a borrower in the future, but it is less damaging than a foreclosure.

How Will a Short Sale Affect Your Ability to Get a Mortgage in the Future?

On average, most people who sell a home for a short sale have to wait about two years (24 months) before they will qualify for a loan with a reasonable interest rate. If you allow your home to foreclose, you may not qualify for a loan for up to six years.

Misconceptions About Short Sales

Because short sales are getting so much publicity right now, a lot of people think they are a good deal. Make sure you aren’t tripped up by the following misconceptions:

Thinking Your Lender Will Approve a Short Sale Just Because Finances are Tight

You’re going to have to prove you absolutely need a short sale, not that you just want one. Your lender will examine your financial condition before approving a short sale, and if it is discovered that you just spent a boatload of money on a vacation or a new car or that you have assets that can be liquidated, you won’t be approved.

Thinking You’re Off the Hook Financially After the Short Sale

You may be done with your obligation to the lender, but you’ll probably have to pay taxes on whatever amount you were short. If you were short $25,000 (as in the example above), the government may consider that $25,000 as income and tax you accordingly. (Check into the details of the Mortgage Forgiveness Relief Act to see if you can possibly be exempt from this tax burden.) Make sure you’ll be prepared to pay those taxes before agreeing to a short sale.

Thinking You Must Wait to be in Default Status Before Approaching Your Lender About a Short Sale Possibility

Actually, you’ll fare better if you approach your lender as soon as you are aware that may have to either foreclose or sell short. Approach your lender will concrete evidence that you cannot make payments or that you have to sell short or foreclose. The more solid the evidence, the more likely the lender will agree quickly to the short sale, making it possible for you to preserve your credit as much as possible.

Short Sales Conclusions

A short sale is usually a better option (for you, the seller) than a foreclosure. Make sure you check out your options thoroughly before deciding to move forward with either a foreclosure or a short sale, seeing as both options will affect your credit.

Before you approach your lender to negotiate a short sale, you’ll want to check to see if your home is indeed underwater. You may wish to get an official appraisal or use an online home value calculator to determine how much your home is currently undervalued. You may also want to talk to a realtor to get a fair market comparison estimate. Collect your evidence that you need the short sale, and schedule a time to discuss this with your lender.