Of short selling a house

I am often asked about short selling a house and/or foreclosure. 

What’s the better route?  How do you negotiate the former?  What are the impacts of the latter?

The short answer: it is much better to short sale than to foreclose.  Read on for some thoughts on short selling a home.  I will write up another post on foreclosure in the near future.

If you have a home that is under water – that is, the mortgage value is greater than the house will sale for – you have options.  Before we discuss those options, there is an important principle you should understand regarding how banks sell you a mortgage.

The common perception of a mortgage is that a bank has lent you money from a collective pool of fellow citizens whose funds are in the same bank.  In this scenario, if you default on your loan, you are “taking money from the bank and neighbors.”

This is not true. 

Banks are able to loan money using a fuzzy math system called “fractional reserve lending.”  In this system, a bank is only required to have a portion of the money on hand that they lend.  They are literally allowed to “create money.”  The percentage rate they are allowed to have used to be 5%; it is now 10%.  As an example, if you purchase a mortgage for $100,000, the bank only sets aside $10,000.  Further, the loan is not a debt on the banks book, it is an asset.  This has further positive benefits for the bank.  For our purposes here, the takeaway is that the bank only spends $10,000 to buy the house.  This is important because a lot of people think they are costing the bank money (and thus, their neighbors).  This is not the case.  If you succeed it short selling your house, as long as you sell it for what the bank reserved ($10,000 in our example), plus any profit the prior homeowner took away in cash, you haven’t cost the bank any money.  At most, you’ve cost them future free profit.

So you’ve made the decision to sell the home. 

Rule #1: TAKE NOTES.  Get a legal pad and document every conversation.  Get the name (if they’ll give it to you, employee # if not) of every employee of the lender you talked to, the date and time you talked to them, and what was said.  This will be useful in keeping track of the sale as well as holding the bank accountable to their statements later. Several times when I was selling our home, the bank told me “we didn’t say that,” or some variation thereof.  I challenged them to pull the recording, offering the date and time the call took place and with whom I spoke.  It limits their wiggle room.  They’ll still wiggle but you can limit it.

Okay, so you’ve made the decision to sell. 

If you are underwater, you still don’t have to do a short sale.  You can sell the home for the market cost and sign a promissory note with the bank.  The promissory note is a legally binding contract with the bank to pay them money.  Using our $100,000 dollar home as an example, if you are only able to sell it for $75,000, you can ask the bank for a promissory note for the remaining $25,000.  You can also ask for terms like 0 or 1% percent interest over 10, 15, or even 30 years (a $25K loan at 1 percent over 10 years equates to app. $219 per month).  Remember, this is pure profit for the bank.  They are likely to accept this deal over all others.

If you do not have the money to pay this promissory note or do not want to, your next option is a short sale with a “full release of liability.”  In this scenario, you are asking the bank to allow you to sell the home and not come after you for the remaining money “owed.”  I’ve put the “owed” in quotations as a reminder that the bank did not really lend you the money they are saying you owe them.  However, by the rules of the mortgage game today, you effectively owe that money and so, need the full release of liability.  This is extremely important.  If they let you sell the house but don’t put the release in writing, they can sue you for the remaining money (research deficiency judgments).  Even if they choose not to sue you, they can sell the debt to a debt collector who will then chase you for the money. 

If you want to pursue either of the options above, your first step is to put the house on the market for whatever the market will bear.  You MUST have an offer in hand when you go to the bank.  If you go in with the offer and are willing to make up the difference in the form of a promissory note, there is a good chance the bank will agree straightaway. 

Regarding the short sale with no promissory note, the bank is going to reject the first offer as being too low.  In rejecting the offer, the bank will tell you the amount they need to get to approve it.  E.g., an offer for $75K on a $100K mortgage will probably be rejected.  In the rejection the bank will say, “We need $5K more.”  Here is where you can offer to cover the $5K in the form of a promissory note or can go back to the potential buyer and let them know the bank wants $5K more.  The buyer may agree, or they may walk away.  If they walk away, you at least know what you need from the next buyer and you know what the bank will take as payment. 

There is one component of this last scenario we haven’t talked about yet (the scenario where you are asking the bank to let you sell the home and take a “loss”).   That component is default.  It is very unlikely the bank will let you short sale a home in which you are paying the mortgage.  This applies specifically to the second scenario (in the first, you are making the loan whole by offering a promissory note).   From the bank’s perspective, if you are paying the mortgage, why should they take a loss?  They do not care how you are paying the mortgage; so long as you pay it, even with a credit card, they will not approve a short sale. 

What does this mean? 

If you are going to ask the bank to take a loss, you are 99% surely going to have to default on the loan.  If you are current on the loan and ask them to take a loss, they have no incentive to do so.  You have to make it “hurt.”  You have to get them to notice your loan.  You have to prove the home is not affordable for you.  In stopping the payment, do NOT spend this money.  Put it in the bank and leave it.  Do this for two reasons: 1) you may need the money to settle with the bank and, 2) don’t pay down other debt (this is called preferential payment of creditors and is not looked upon fondly in bankruptcy).  Okay, there’s a number three: at NO time in the default/short sale process should you send any money to the bank.  Tell them you will bring any settlement money to the closing table.  If you send them a check to “Square up the loan so they will approve the short sale” and the sale falls through…you are out that money.  They will not give it back.  Legally, it would be their’s to apply to the overdue loan.

A brief word on affordability: if a mortgage payment is eating up more than 30% (and that’s high) of your take home pay, the home is not affordable.  If the same payment is eating into your savings, it is not affordable.  If the same payment is preventing you from saving, it is not affordable.  Affordable means you are setting aside money for savings and retirement, as well as making payments on any other debt you have.  Do not be consumed by the belief you owe the bank 30 years of your working life. 

This will impact your credit but not to the degree most people think.  I short sold a house in Las Vegas using this method and the overall impact to my credit was app. 90 points.  Two years later, thanks in large part to the full release of liability and the way I negotiated the credit statements be worded, we qualified for another mortgage. 

A word on the release of liability: in addition to the stated “full release of liability from the lien,” you want to negotiate that the lender issue a 1099-C.  This is a statement to the IRS that they are cancelling the debt.  Further, to mitigate the credit impact, you want to negotiate the lender report the sale to the credit bureaus as a “Paid in Full.”  They will most likely balk at this; “allow” them to negotiate back to a statement that reads, “Paid in full for less than the amount owed.”  It makes a difference to the humans who will read the credit report when you apply for your next mortgage (I am not sure if it makes a difference to the credit bureaus in terms of raising your score). 

This is the general overview of the process.  I intend to add to and edit this as additional thoughts come to mind.  More to follow!

DISCLAIMER:  I know of what I speak (type), having gone through this process myself.  That said, ALWAYS validate any information you find on the Internet or are told by someone.  In this case, I recommend you talk to a bankruptcy attorney, real estate agent, and tax advisor about the implications of selling the home.  Do this before acting on my wise and sage advice above. I have no skin in the game; I simply want to ensure people know their rights.

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