Facing a foreclosure? You might have heard that a short sale could be the solution to your problem. Short sales often work out well for people, but it’s not a good idea for everyone, and it’s not appropriate in all situations. Consider the following before deciding on a short sale of your home.
A short sale is a sale of a property where the proceeds of the sale are less than the balance owed on the mortgage loan covering the property. The bank agrees to accept the proceeds from the sale in exchange for releasing the lien on the home. (To learn more about how to do a short sale, read Short Sales vs. Deeds in Lieu of Foreclosure.)
While a short sale is one way to avoid a foreclosure, these sales have certain disadvantages and risks.
Preserving your credit score might be the most touted reason for choosing a short sale of your home rather than letting it go through a foreclosure sale. But the reality is that a short sale isn't much better for your credit score than a foreclosure. Short sales, foreclosures, and deeds in lieu of foreclosure are all about the same for purposes of your credit score. Only bankruptcy is worse for your credit.
Exactly how much your score will drop depends primarily on what information the servicer reports about the short sale and your credit history. If you have a high credit score before doing a short sale, which is unlikely if you're behind in mortgage payments, you’ll lose more points than someone with a low credit score. And if you avoid owing a deficiency (see below), your credit score might not take as big of a hit. Overall, though, the difference in how much a short sale or foreclosure affects your credit is pretty minimal.
You might be surprised to learn that a short sale doesn’t automatically cancel your obligation to pay off the remaining debt on your mortgage loan. Here's why: The two documents used in a typical home loan transaction are a promissory note and a mortgage (or deed of trust). The promissory note consists of your promise to repay the lender. The mortgage (or deed of trust) creates a lien on your property. In other words, if you break your promise to repay, the lender has the right to have the property sold to pay off the loan. So, when a lender approves a short sale, what is the lender agreeing to do? At the very least, the lender agrees to remove or release the lien on the property. A seller would have a near-impossible task in selling a property without this lien release. But is the lender also agreeing to cancel the borrower's obligation to repay the loan in full? Not necessarily.
Some lenders ask borrowers to sign new, unsecured promissory notes before approving short sales. Other lenders, without asking for a new promissory note, reserve their right to collect the deficiency—the remaining balance of the debt—as part of a short sale agreement. After the short sale closes, the lender starts collection proceedings. Other lenders assign the debts to collection agencies, which then go after the borrowers for repayment after short sales. But in a couple of states, you can't be sued for a deficiency after a short sale.
To be sure that you won’t be on the hook to make any more payments after your short sale closes, ask your lender to waive the deficiency and get it in writing. If your lender refuses to forgive the deficiency, consider talking an attorney to see if any state laws prohibit your lender from collecting the deficiency.
Even if your lender forgives a deficiency, though, you might owe taxes on the forgiven amount. That's because the IRS generally considers forgiven debt as income.
If you do face income tax liability, you might be able to avoid paying it if you qualify for an exception or exclusion, like insolvency. Contact a tax professional or attorney in your area to find out whether you’ll owe any taxes as a result of your short sale.
Still can't decide if a short sale is right for you? Here's some more food for thought.
A short sale can take a long time and a lot of work, with no guarantee that it’ll close in the end. Before embarking on a short sale, you might want to contact your servicer about other ways you might avoid a foreclosure, like by modifying your loan or getting a deed in lieu of foreclosure. Like short sales, these alternatives have drawbacks and benefits to consider before proceeding. For more information on alternatives to foreclosure visit our Alternatives to Foreclosure page.
An approved agreement for a short sale transaction might include a marketing or listing period during which the borrower may market the property, and the lender won't foreclose. If you don't have an approved short sale transaction by the end of the marketing or listing period, the lender can generally go forward with the foreclosure.
Is there a second loan on your home? Do other creditors hold liens on your property? You’ll most likely need the approval of all parties with an interest in your property in order to close the short sale. The time and effort needed to close a short sale increases exponentially with each additional interested party. If you decide to proceed with a short sale, you should identify all parties with an interest in your property and contact them early in the process.
To learn more about whether a short sale is a good option for you, as well as get information about other alternatives to foreclosure, consider talking to a foreclosure attorney. If you can't afford an attorney, a HUD-approved housing counselor is an excellent resource who can help you for free.