Although both result in giving up a home that homeowners can no longer afford, short sales and foreclosures differ in many key ways. The main difference is that a short sale is a voluntary process initiated by the seller, while a foreclosure is an involuntary process initiated by the lender. Once a lender proceeds with legal action toward foreclosure, the homeowner loses control of all decisions and outcomes regarding the property.
Fortunately, homeowners can act before a foreclosure occurs by pursuing alternatives, including a short sale. To choose between a short sale or foreclosure, homeowners must be informed about each process. Additionally, buyers who are interested in foreclosed or short sale properties for sale should be informed about how either option can provide them with a way to secure their ideal property.
In order for a property to qualify for a short sale, the lender must approve the transaction; after this approval, the lender is able accept offers below the market value of the home—and the total owed on the mortgage. A short sale causes the lender to lose money because the homes involved in a short sale rarely sell for more than the loan balance. In many cases, the lender forgives this deficiency, freeing homeowners from further payments in the future. Therefore, the lender needs to have a complete idea of the hardship that the homeowner faces in order to accept the loss.
Homeowners need to submit a hardship letter detailing their financial difficulties if they plan to list their home for a short sale. Commonly accepted reasons for financial difficulties include:
- Job loss
- Pay cuts
- Serious illness
Less common reasons for financial difficulties include a change in the mortgage terms, such as an increase in rates, or the need for major repairs on the home.
Upon review of the hardship letter, the lender will decide to approve or deny the short sale. If the homeowner receives a denial letter from the lender, the homeowner can review and rewrite the letter and try submitting it again. With approval, however, the homeowner can work with a real estate agent to place the home on the market and work toward finding a buyer. Sellers should anticipate the process taking some time, as short sales can be a lengthy process.
When compared to foreclosures, short sales offer benefits to the homeowner, the prospective buyer, and even the lender. Although the lender will need to accept part of the mortgage at a loss, a foreclosure can end up costing the lender even more time and money. If the homeowner qualifies for a short sale, the lender avoids having to complete repairs and otherwise prepare the property for the market as well as save money by not having to:
- Cover court fees
- Complete evictions
- Process paperwork
Once the home sells, the lender can write off the difference as a loss and avoid covering other administrative costs along the way. In some cases, lenders can recoup the losses with a deficiency judgement through the court. If the lender is allowed to do so, the homeowner will need to cover the difference by making regular payments to the lender.
Because foreclosures can also result in deficiency judgements in certain circumstances, short sales are often the better option for homeowners because unlike foreclosures, short sales allow homeowners to remain involved in the process. Short sales allow homeowners to work with a real estate agent to prepare the home for the market, meet with buyers, and try to sell their property for the highest price. They do not lose control of their outcome, which can prove calming during this difficult time.
Because short sale properties often go for much lower than market value, buyers will benefit from these transactions, as they can often find homes listed for up to 50% of the market value, plus they can secure favorable terms on their own mortgage loans.
For all parties in a short sale, the disadvantages of the process involves the extensive timeline, with some of the longest factors including approval from the lender and closing. Not many people are prepared to spend the time waiting to buy or sell a property.
The approval process tends to take the longest because lenders must send the hardship letter and offer to many parties, and each party needs to sign the agreement. If any party does not approve, then the homeowner must start the process over, which is often the case when multiple lien-holders have a stake in the property.
Furthermore, because lenders are looking to minimize their losses in the short sale process, many lenders will submit a counteroffer to the buyer rather than accept the buyer’s initial offer. Additionally, buyers will need to consider the opportunity costs when buying a short sale. For example, as buyers wait for approval of their offer, they may miss the opportunity to explore other ideal properties.
Because short sale properties are often sold as-is, buyers assume full responsibility for any necessary maintenance and repairs. This differs from non short sale properties, as buyers may negotiate with the seller to have problems fixed before closing. However, buyers do have the option to bring in an inspector, which can minimize their risks when buying a short sale. If the inspection reveals any major issues, the buyer should be prepared to walk away unless they can negotiate the price down enough to cover the repairs.
Throughout this process, the current homeowners hold out hope the sale will go through. If they cannot find a buyer or the lender rejects all offers, the homeowner may still end up in foreclosure despite their best efforts.
In many states, if homeowners fall behind on their mortgage payments, lenders begin the foreclosure proceedings. Foreclosure leads to the lender seizing the property, which ends the homeowner’s mortgage agreement and eventually evicts the homeowners. Once foreclosure has begun, the lender can sell the property on the market to recoup their losses. While the foreclosure process varies from state to state, and there are different avenues for homeowners to stop a foreclosure from going through, the end result is the same.
Homeowners can choose to pursue alternatives to foreclosure to retain ownership of the property or minimize their own losses. Short sale is just one of many possible alternatives, with other options including:
- Loan modification
- Quitclaim deed
- Deed in lieu of foreclosure
No matter which option homeowners choose, they must act fast in order to avoid foreclosure. Once a homeowner knows they will not be able to make their mortgage payment, it is time for them to call their lender. Otherwise, lenders will proceed in completing the foreclosure process, making it difficult to for homeowner’s to avoid.
If homeowners decide to abandon the home, foreclosure will likely move forward immediately because lenders cannot afford to leave the residence unoccupied as missed payments add up, especially if the home will fall into a serious state of disrepair as a result.
Because they are listed for below market value, foreclosed properties are a solid choice for buyers who have a budget or want to save money in their home purchase. Although buyers will not save as much as they can with a short sale property, foreclosed properties may allow buyers to get their ideal residence at a lower price.
Unlike with short sales, foreclosures do not offer as many advantages to the buyers, lenders, nor current homeowners. For many lenders and homeowners, foreclosure is a last resort, which is why so many alternatives are offered and persued instead.
Buyers are set to reap the most rewards during the foreclosure process, as foreclosed properties come at a lower price than other properties on the market. Most foreclosed properties are sold at the total amount owed on the mortgage, which can be 20% to 50% lower than its market price in certain areas. The lender aims to collect the loan balance and any repair expenses they covered to ready the property for the market.
Compared to a short sale, waiting periods during the foreclosure process are shorter because the offer does not need approval from as many parties. During a foreclosure, the lender only needs to verify that the offer exceeds the balance on the loan in order to approve the sale. As long as this requirement is met, the lender will usually grant their approval and accept the current offer.
Because approximately half of foreclosures are sold as cash only, buyers often face less competition during the bidding process, thus decreasing the chance of a bidding war.
There are many disadvantages of foreclosure for both lenders and homeowners. For example, lenders lose more money in a foreclosure compared to a short sale, as the lender must pay for administrative costs to process the foreclosure plus cover the expense of evicting the residents. Once the lender has the home in their possession, they must pay for an inspection and any necessary repairs to prepare the property for the market. Once this has been completed, the lender will need to hire a real estate agent, find a buyer, and navigate the closing process. Because each factor costs the lender a considerable amount of money, many lenders will consider alternatives to foreclosure.
Additionally, the disadvantages for homeowners during a foreclosure include:
- Lack of control over the process
- Decline of credit scores
- Inability to secure a mortgage loan for up to seven years
Although it also results in the loss of the home, a short sale allows people to secure a new mortgage loan when their finances recover and to start anew without a mandatory waiting period. While it does impact credit scores, a short sale does not compare to the credit score impact resulting from a foreclosure. Unlike a foreclosure, homeowners stay in control of the short sale process from beginning to end.
While buyers usually win with the purchase of a foreclosed home, this is not always the case. For example, when buyers purchasw foreclosures at an auction, the properties are sold as-is and without a guaranteed clear title. Additionally, if there are any liens on the property or if the residence need repairs, the buyer will be responsible for those costs.
If the foreclosed property is purchased as a real estate owned, or REO, residence, then it will likely have a clear title because foreclosures only move into REO status once an auction fails. However, this will extend the waiting period of the buying process.
If buyers have their heart set on a particular property, they risk losing their chance of ownership to the highest bidder during an auction. Buyers may feel pressure to bid higher, even if this means taking on additional financial obligations with the purchase. Obtaining title insurance while in escrow or at closing can help with these financial obligations, though it is not a guaranteed solution.
What is the Better Option?
Although there are many reasons for choosing a short sale over a foreclosure, this decision should be made with legal and tax advice before moving forward in any direction. Homeowners will need to review their financial situation in detail in addition to their future goals for homeownership. If homeowners plan to buy a property in the near future, a foreclosure may defer this plan for seven years or more. However, if homeowners do not expect their financial situation to change in the coming years, then a foreclosure may be the right option.
Homeowners should always consult with a professional to retain more control over the outcome of their home. Additionally, homeowners should contact their lender if there are any signs of financial difficulties that will prevent the homeowner from making an upcoming mortgage payment.
A rea estate professional or a lender can help homeowners in their situation and provide them with the tools homeowners need in order to protect their finances. With professional help, homeowners can evaluate short sales and foreclosures to determine if either option will benefit their situation. Homeowners can also receive help with examining other alternatives to foreclosure in case there is a better solution available.