Recently I have received a number of emails and calls from San Jose and Silicon Valley homeowners who are “upside down” in their homes and want to sell that property and “move up” into a bigger house, better neighborhood, or higher performing school district. They contact me to see if they can do a short sale and get out from under their loan, and several seem to think that they can pull equity out from that property to purchase the next home.
It doesn’t work that way.
There are a lot of misconceptions about short selling a home, and what a short sale is, and who qualifies for a short sale, so this post is aimed at clarifying what it’s all about.
A “short sale” is a sale of the property in which the lender (or lenders) accepts a “short payoff” to get the home conveyed to the new owner. The “short” in short sale refers to the lender not getting paid back what was promised by the borrower/homeowner.
Why would a lender agree to taking less than what is owed? The answer is simple: only if it’s the lesser of two evils, the other being a foreclosure (which would cause a greater loss to the lender in most cases).
Under what circumstances will a lender agree to a short sale? There are a few conditions which absolutely must be met if a seller will even consider a short payoff:
- The homeowner has some sort of significant hardship (such as the death of a spouse and loss of that spouse’s income, divorce, job loss, serious medical illness with large medical expenses)
- The monthly payments can no longer be made (in part or in full)
- The owners or property does not qualify for a loan modification
- The property owner has no other assets which could be sold to make up the difference between sale price and loan balance (such as a vacation home, stocks, etc.)
- In many cases, lenders will not consider a short sale unless payments or parts of payments have been missed (the owner is in or near default status)
A few very significant ramifications occur when there is a short sale:
- The seller cannot take away a penny from the sale
- The seller’s credit is seriously damaged (it’s about half as bad as a foreclosure in terms of harm to a credit score)
- The seller will be unable to buy a replacement home for a few years
- In some cases, the seller may owe money to the government on the “forgiven debt”, which may be considered a “taxable gain” (some owners qualify for protection from this, but if owners cashed out with a refinance that may not be the case – with a few exceptions)
- In some cases, the lenders can still pursue the former homeowner on the difference between what was owed and what was paid
In other words, a short sale is not a way to get rid of a home you no longer want so that you can get your original downpayment back and buy something better. You and the lender have a shared risk from the moment you closed escrow on that home. Your risk was your downpayment and the amount you paid each month. The lender’s risk was the amount it provided to you so that you could purchase that real estate (or to refinance it later).
A strategy that some unhappy homeowners have used until fairly recently is “buy and bail”. Buy the move-up home first, then walk away from the old home, either trying for a short sale or simply permitting a foreclosure. Banks are onto this approach and have made the criteria for borrowing on the next home more difficult. They want to see at least 30% equity in the current home, see more cash reserves in your bank account and other guidelines to boot. The last thing a bank wants right now is a borrower willing to default on a loan.
If you are in a financial corner and see that foreclosure is inevitable, then perhaps a short sale is right for you as a way of mitigating a very bad situation.
If, however, you want to move up and simply feel trapped because your current home has lost value, a short sale is most likely not going to be your recourse. Wanting a bigger home is not a hardship, even if there’s a new baby or two on the way.
Want more info on how a short sale works? Here are a couple of good articles: