Understanding short sales

Now that property values are rising, the opportunity to reduce your debt load through a short sale will close for many Americans.

by Brandon Lafving (@TechDragoon)

Homeowners who can no longer afford to pay their mortgages consider bringing their financial lives under control with a short sale. For many, a short sale can result in stability without the severe consequences of foreclosure or bankruptcy.

Underwater Mortgages

The housing crisis in the 2000s substantially reduced property values across the United States. For homeowners who kept their jobs or who were OK financially, the change in value might not have meant much. But for many individuals who were in homes they could not afford, the depreciation in value locked them into a situation of escalating debt.

READ: Should I buy points on my home loan?

Eroding property values outpaced the payments many borrowers were making on their mortgages, leading to a greater deficit than the current value of the home. These are called 'underwater mortgages,' the water of this analogy being the debt, which has risen over the real value of the home. Once a mortgage is fully submerged, the owner can no longer sell the property because the sale would not fulfill the full balance of the mortgage.

You might also be considering in this case Chapter 13 Bankruptcy, or facing foreclosure proceedings. But a successful short sale is often preferable over these options.

How It Works

A short sale is a form of debt settlement, wherein your creditor agrees to fulfill your mortgage's full value without full payment. You find a new buyer who will pay, say, 85% of your mortgage in a new deal with the bank, and the bank lets you off the hook for the remaining 15%.

READ: 5 cities with terrible break-even points for homebuyers

We all know that banks are not 'nice,' so why would they accept less than full payment? Consider the alternative.

Banks can let you default on your payments, or they can foreclose on the property and, after a lengthy process in court, they end up selling the property to someone else anyway in an auction. The process depreciates the land value even more and can result in a worse deal for the bank.

So a short sale is a way out of the dark spiral for both you and your bank. For you, avoiding foreclosure saves a couple hundred points of penalties on your credit rating and results in a shorter waiting period before you can finance your next home.

Short sales are not easy to accomplish. Like all negotiations, they require the right timing and management. That is why you should also be warned of the dangers before you proceed. Read my article next week on short sales for more tips on how to make a short sale work for you.