Understanding the Short Sale for Mortgage Originators

by 03 Mar 2008

The new niche market.

What is the short sale?

Today?s real estate market has experienced a plethora of foreclosures and bankruptcies due to several instabilities within the US real estate market. As home values continue to fall and real estate sales slow down, many homeowners are finding themselves owing more than their homes are worth in the declining market. This is often referred to in the mortgage industry as being ?upside down.?

Typically, this would not be a detrimental issue, but coupled with the rising interest rate increases of adjustable rate mortgages (ARMs), the market has fostered a short sale environment. The sub-prime market, in particular, has suffered the worse fall out throughout the country as many loans have gone into default, foreclosure rates have risen and lending institutions have folded. When consumers find themselves ?upside down? in property value, unable to afford their adjusted mortgage payments and delinquent on their home loans, they are often forced to financially weather the storm, foreclose on the property or engage in a short sale of the home.

A short sale occurs when a bank opts to work with the homeowners to sell the property in lieu of foreclosure. In most investment scenarios a short sale occurs when stocks are borrowed from a stockbroker?s inventory and then sold at a particular price with the hopes of that stock?s price declining within a given period. If the stocks fall as hoped, the investor will purchase the stocks at the new, lower price and return the borrowed shares to the inventory from which the stocks were borrowed and possess a handsome profit. However, in the real estate market, the term ?short sale? is a far cry from an investment strategy. Since the home?s value is less than what?s owed on it, a sale of the property for the lower fair market value as opposed to the higher amount owed on the mortgage would leave a shortage in the sale proceeds?hence the term ?short sale.? This type of sale creates a profit loss for both the homeowner and the bank, but has become prevalent enough that you should be familiar with the particulars of such a transaction.

Why would someone want to engage in a short sale?

According to the National Association of Realtors, existing home prices have fallen on average more than 6% over the last year. However, many markets have seen their home values drop as much as 25% over the last two years. This drop in housing values equates to an extreme loss in equity for many. Experts profess that it was inevitable as the housing ?bubble? was bound to correct itself after the rapid rise of home prices from 2002 - 2005. Although local housing markets generally experience periodic peaks and valleys in home equity appreciation, the onslaught of short term Adjustable Rate Mortgages left many homeowners faced with adjusting mortgage payments that are well out of the realm of affordability. Furthermore, borrowers are unable to refinance their existing loans because they owe more than the appraised value of the property.

As the US real estate market deals with a projected 2.4 million foreclosure incidence for 2007, homeowners are scrambling to find solutions. Currently, existing-home inventories in the US are listing ?For Sale? for over eight months and newly constructed homes for six months. A recent report by Merrill Lynch states that over 60% of homes currently on the market are listed for selling prices well above what the current market will bear. Banks have begun to react to these statistics by allowing delinquent homeowners to sell their homes for a market supported price that is under the balance of the mortgage lien, thus creating a short sale. However, banks are reluctant to accept any losses on loans and the homeowner must be able to demonstrate an undeniable inability to pay the monthly mortgage or be prepared to payoff all or part of the balance on the note.

Why is a short sale a good option?

Short sales offer a great option for homeowners to relinquish their home without having a foreclosure entry placed on their credit profile or facing a slew of lawsuits and judgments after the foreclosure auction has occurred. Additionally, once the mortgage debt is satisfied, many homeowners can escape filing for bankruptcy, which may have been prompted due to any balance left over from a foreclosure auction or voluntary abandonment. Often times the bank will even set up interest free payment plans for the short sale balance. However, do not plan any course of action expecting the lender to offer debt forgiveness or payment plan options. First and foremost, banks are concerned with getting the loan repaid. In a short sale transaction, the bank is also able to waive the costs of collections, auctions, advertising legal notices, attorney fees and other expenses usually incurred when foreclosing on a property. Additionally, the bank can report the debt as ?closed? and/or ?paid? and not as a foreclosure to their shareholders. Although the homeowner is still obligated to move out of the property, they are able to maintain some ground on their credit profile, putting them in a better position to buy again sooner rather than later.

What are some things to consider in a short sale?

Short sales seem like a great way to sell a home that would otherwise sit on the market because of an inflated mortgage balances in a sagging market. However, they do come with their consequences to the buyer. Financing of a short sale property is not too different from any other purchase transaction. However, the banks are very concerned that the absolute best price is being paid to cover as much of the underpaid mortgage balance as possible. Often time short sales can take 45 ? 60 days to close. Therefore, it is important to involve a good title/settlement company that will be able to facilitate all public records, assessments and any additional lender requests in a timely manner. Moreover, it?s not uncommon for the seller?s lender to disallow closing costs contributions to the buyer as in traditional purchases. Buyers should be prepared to pay their own closing costs. Buyers should also insist on a home inspection as often times maintenance of the subject property is neglected due to previous financial restraints of the seller. Keep in mind also, that any major defects reported by an appraiser can raise a red flag to an underwriter, who in turn, may require that the defect be repaired before the new loan can be cleared to close. Also be prepared to negotiate the terms for curing any damages or structural issues as they often times arise.

A seller, on the other hand, needs to be cognizant of a potential tax liability in a short sale transaction. Banks will typically send a 1099 income statement at the end of the tax year in which the short sale occurred. Any unpaid balance is reported as income to the seller. In effect, a seller may be left facing additional income taxes on the unpaid balance of their home. So if a home with a $500,000 mortgage balance, sold at a short sale for $400,000, then the seller would receive a $100,000 1099 income statement and be responsible for paying taxes on that $100,000 income.


The Mortgage Bankers Association reported that the percentage of mortgages entering foreclosure in the US, which is about one in 172 loans in the first quarter of 2007, was the highest in more than a half century, with sub-prime borrowers suffering the worst. Thousands of recipients of adjustable-rate mortgage loans are seeing rates adjust beyond their means. Teaser interest rates have expired and many borrowers find themselves in negative amortization. These loan scenarios, combined with already declining property values, increased credit challenges and few to no options for stabilization, require a thorough understanding of short sale transactions and how they should or should not be utilized in today?s real estate market. Know the facts and make informed decisions?as it will have a ripple effect on every other financial aspect in your life.

Marcus M. White is a Sr. Mortgage Banker & Manager at Dynamic Capital Mortgage (formerly Pinnacle Financial Corp.), a national residential and commercial lender in Vienna, Va. He is a published author and featured speaker in various media outlets and classrooms. He also is a Certified Mortgage Planning Specialist (TM), financial counselor and former institutional investor, representing clients in complex financial matters. He has significant expertise in sophisticated financing transactions, retirement and investment planning. Contact him at mwhite@dyncap.com or (202) 210-0089.



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