At its core, a short-sale is a property that sells for less than the mortgage, thus “shorting” the lender. For example, let’s say a property was purchased in 2006 for $300,000, and the mortgage on the property was for 95% of that amount, or $285,000. Now, in 2010, let’s say for some reason this property has to be sold, and in this area, property values have gone down by 20%.
Therefore, the current market value of the property is only $240,000. This is the “uh-oh” situation where the mortgage of $285,000 is $35,000 over what the seller is likely to get for the property. In addition, there are costs associated with the sale (broker commission, transfer taxes, title fees, attorney, possible repairs or special assessment) that have to be added to that loss, let’s say an additional $14,000 to get it sold.
Our seller is in the difficult situation of having to either pay the difference of $49,000 out-of-pocket, or try to get the bank to agree to take a loss on the loan, thus creating a “short sale”. The situation becomes even more difficult if the seller defaulted on homeowner association fees or owes on a special assessment.
The above scenario would actually be a better than average situation because in 2006, many banks were allowing buyers not only to finance 95% or more of the purchase, but to also have a second loan (often a Home Equity Loan) to cover their down payment. Therefore, 100% of the purchase was financed and now there will be two loans “shorted”, not just one.
A foreclosure is a process that a lender usually starts once a borrower misses several loan payments. If the property owner can’t pay his fees, and can’t get the property sold, and/or the bank won’t agree to a short-sale, the bank may “foreclose on the property”. The property then becomes bank owned. This is called an REO* property. The person who owned the property loses it, as well as their down payment and any equity they had accumulated. Their credit rating is trashed for years as well due to the total default.
*REO stands for Real Estate Owned; I’m not sure why it’s called that.
Unfortunately, these are terms that are becoming all too familiar.