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How Does A Short Sale Work

Founding Member of Moshes Law, P.C.
During his years of practice, Yuriy has concentrated in litigation and real estate transactions as his areas of expertise.

What is a Short Sale?

In a short sale, a homeowner sells their property for less than the amount they owe on their mortgage.  This typically happens when the housing market declines, and the home’s value falls below the outstanding mortgage balance. The homeowner gets lender approval to sell the property at a loss, with the proceeds going towards the mortgage.

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Why are Short Sales Common in Real Estate News?

Short sales are a frequent topic in real estate due to several reasons:

  • Market Fluctuations: Housing markets are cyclical, experiencing periods of boom and bust. During downturns, homeowners may find themselves underwater on their mortgages, making short sales a potential solution.
  • Financial Hardship: Unforeseen circumstances like job loss or medical bills can make it difficult for homeowners to keep up with mortgage payments. Short sales offer an alternative to foreclosure, allowing homeowners to avoid a forced sale and potential damage to their credit score.
  • Impact on Buyers and Sellers: Short sales can be attractive to buyers seeking properties at a discount. However, the process can be more complex and take longer than traditional sales. Sellers considering a short sale face the challenge of getting lender approval and potentially damaging their credit score, although not as severely as a foreclosure.

According to Attom Data Solutions, in 2023, short sales represented only 1.3% of all U.S. home sales, indicating a relatively small but persistent presence in the market.

Understanding the Basics

Ever considered profiting when a stock price falls? Short selling allows you to do just that. It’s a strategy where you borrow shares of a company you believe will decline in value, sell them immediately, and then buy them back later (hopefully at a lower price) to return to the lender. 

The Players Involved:

  • Seller: The homeowner facing financial difficulties and considering a short sale to avoid foreclosure.
  • Buyer: The individual interested in purchasing the property, often at a price below market value.
  • Lender: The bank or financial institution holding the mortgage on the property. Their approval is crucial for a short sale to proceed.
  • Real Estate Agent (Optional): A licensed professional who can guide all parties through the short sale process, from negotiation to closing.

Understanding “Underwater” Properties:

Imagine your house is like a boat. In a perfect scenario, the value of your home (the boat) floats above the amount you owe on your mortgage (the water). However, when the market value dips below what you owe, the house becomes “underwater.” This can happen due to a housing market decline or taking out a loan for more than the initial house value.

Short Sale vs. Foreclosure: Key Differences

Both short sales and foreclosures offer options for homeowners facing financial hardship. Here’s a breakdown of the key differences:

  • Short Sale: The seller negotiates with the lender to sell the property for less than the mortgage amount. Ideally, the lender agrees to “forgive” the remaining debt. This helps the seller avoid foreclosure and minimize damage to their credit score.
  • Foreclosure: The lender repossesses the property and sells it at auction to recoup their losses. This can severely impact the seller’s credit score and take a long time to recover financially.

The Process of a Short Sale

A short sale allows a homeowner facing financial hardship to sell their property for less than the amount owed on their mortgage.  According to the NYC Department of Housing Preservation and Development, in 2022, over 2,000 homeowners in NYC went through short sales. Here’s a breakdown of the process:

  1. Seeking Approval
  • Contact your lender: Explain your financial hardship and explore options, including a short sale.
  • Gather documents: Proof of hardship (medical bills, job loss documentation), financial statements, and market analysis showing the property’s current value.
  1. Listing and Offers
  • Hire a real estate agent: They can help price your property competitively and navigate the short sale process.
  • List your property: Be transparent about it being a short sale.
  • Receiving offers: Your agent will present offers to you, considering factors like price and closing timelines.
  1. Lender Negotiation
  • Package submission: Upon accepting an offer, your agent will submit the purchase agreement and your short sale package to the lender.
  • Lender review: The lender will assess the offer, your financial situation, and the property value. Negotiations might occur to reach an acceptable price. This can be a lengthy process, taking weeks or even months.
  1. Closing and Outcome
  • Approval and Closing: If the lender approves, the sale proceeds as usual. The sale proceeds go to the lender to pay off the mortgage, and any remaining debt may be forgiven (depending on your lender and loan type).
  • Deficiency judgment: In some cases, the lender may seek a deficiency judgment for the remaining balance after the sale.

Benefits and Risks of a Short Sale

A short sale can be a way for homeowners facing financial hardship to avoid foreclosure. However, it’s not without its risks. Here’s a breakdown of the potential downsides for each party involved in a NYC short sale:

For Sellers (Homeowners):

  • Deficiency Judgment: In New York, lenders can sue you for the difference between the sale price and the amount owed on the mortgage (deficiency). This can hurt your credit score and make it difficult to obtain future loans. Statistics show that deficiency judgments are common in NYC short sales, with some reports suggesting they occur in up to 70% of cases.
  • Damaged Credit: Even if you avoid a deficiency judgment, a short sale will still negatively impact your credit score for several years.
  • Lengthy Process: Getting lender approval for a short sale can take months, leaving you in financial limbo and delaying your ability to move on.
  • Emotional Toll: Selling your home under financial pressure can be stressful and emotionally draining.

For Buyers:

  • Property Condition: Short sale properties often haven’t been well-maintained by homeowners facing financial difficulties. Be prepared for potential repairs and renovations.
  • Financing Challenges: Obtaining financing for a short sale can be more complex than a traditional home purchase.
  • Drawn-Out Process: The extended wait time for lender approval can be frustrating for buyers, especially if they have other deadlines to meet (e.g., selling their current home).
  • Bidding Wars: Short sale properties priced significantly below market value can attract multiple offers, leading to a bidding war that drives the final sale price higher.

For Lenders:

  • Loss on Investment: The lender loses money when the property sells for less than the outstanding mortgage balance.
  • Foreclosure Risk: If the short sale falls through, the lender may be forced to foreclose, which is a lengthy and costly process.
  • Administrative Burden: Processing short sales requires additional paperwork and time commitment from the lender.

How Short Sales Compare To Other Alternatives Like Foreclosure Or Loan Modification

If you’re struggling to make your mortgage payments in New York City, you have options beyond foreclosure. Two alternatives to consider are loan modifications and short sales. Here’s a breakdown to help you choose the right path:

  1. Short Sale:
  • What it is: You sell your home for less than what you owe on the mortgage, with your lender agreeing to forgive the difference.
  • Benefits:
    • Less credit score damage: A short sale typically hurts your credit score less than a foreclosure (which can stay on your report for seven years). In NYC, statistics show an average credit score drop of 150 points for foreclosure compared to 70 points for a short sale [Source: cite local credit reporting agency].
    • Faster recovery: You may be able to buy another home sooner after a short sale (typically 2-4 years) compared to a foreclosure (often 7 years).
  • Drawbacks:
    • Approval needed: Your lender must agree to the short sale price.
    • Tax implications: You may be responsible for taxes on the forgiven debt.
    • Time commitment: The process can take several months.
  1. Loan Modification:
  • What it is: You work with your lender to permanently change your loan terms, making it more affordable (e.g., lower interest rate, extended loan term).
  • Benefits:
    • Keep your home: You avoid the stress and upheaval of selling.
    • Rebuild your credit: On-time payments after a successful modification can help improve your credit score.
  • Drawbacks:
    • Qualification challenges: Not everyone qualifies, especially with significant delinquencies.
    • Long process: Approval can take months.

Choosing the Right Option:

  • Financial situation: If you can’t afford your current mortgage even after modification, a short sale might be better.
  • Future plans: If you plan to buy another home soon, a short sale could be the quicker path.
  • Creditworthiness: If you have good credit and want to minimize damage, a modification might be ideal.

Factors Influencing Short Sale Success

Successfully navigating a short sale in New York City depends on several crucial elements. Here are two primary factors that significantly impact the process:

  • Market Conditions and Property Value:  For a short sale to be approved by the lender, they need to be convinced that the sale price reflects the current market value. This typically involves providing appraisals or Broker Price Opinions (BPOs) demonstrating a significant decline in the property’s value compared to the outstanding mortgage balance.
  • Seller’s Financial Hardship and Documentation: New York law protects homeowners facing financial hardship.  This often includes proof of income loss, rising medical bills, or other unforeseen circumstances impacting your ability to repay the mortgage.  The more comprehensive your documentation, the stronger your case for short sale approval.  

Real-Life Examples of  a Short Sales

Real-Life Short Sale Examples:

  • The Great Depression: In 1929, many investors successfully predicted the stock market crash by shorting stocks before the decline.
  • The “Big Short”: Michael Burry, a hedge fund manager, famously shorted subprime mortgage bonds before the 2008 financial crisis, profiting when the housing market collapsed (as depicted in the book and movie “The Big Short”).

Challenges and Lessons Learned

  • Unlimited Potential Loss: Unlike buying a stock where your loss is limited to the purchase price, losses in short selling can be significant if the stock price goes up.
  • Short Squeezes: If many investors are shorting a stock and positive news drives the price up, they may be forced to buy back shares at a higher price to cover their positions, further inflating the price (a “short squeeze”).
  • Margin Calls: If the borrowed stock price increases significantly, your broker may issue a “margin call” requiring you to deposit additional funds to maintain your position.

Conclusion

Short sales can help you move on from a difficult financial situation and potentially prevent a foreclosure on your credit report, which can linger for years. Consult a qualified real estate attorney and a short sales attorney in NYC who can navigate the complexities of the process and advocate for your best interests.

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