When a borrower consistently fails to make mortgage payments, the property is foreclosed upon. In a foreclosure, the lender assumes ownership of the property and evicts the borrower. Foreclosed properties may be sold at an auction or via traditional real estate agents. For borrowers, a foreclosure badly damages their credit score.
A short sale is often used as an alternative to foreclosure because it mitigates additional fees and costs for both the creditor and borrower. The negative impact on the borrower's credit score is typically smaller in a short sale than in a foreclosure, but a short sale usually involves a lot more paperwork for all parties.
Eligibility and Use
Foreclosures are used when a homeowner has defaulted on their home loan payments. The lender takes possession of the property, which was pledged as collateral for the loan. After a property is foreclosed upon, the lender puts it up for sale and uses the proceeds to recover the mortgage balance.
Short sales are available to borrowers when they owe more than their home’s current worth on the market. Short sales can be used both in situations where the homeowner is current on their mortgage payments and when they have fallen behind. However, lender approval is required before a short sale can be completed; lenders are not obligated to accept a short sale.
How Do Foreclosures and Short Sales Work?
Depending upon the state a borrower lives in, foreclosure may or may not involve the court system. See Judicial Foreclosure vs Non-Judicial Foreclosure for more information.
After three to six months of missed payments, a lender will record a notice of default, which notifies a borrower that he is facing foreclosure and gives him a reinstatement period to make things right by paying off debts or settling any other disputes. The length of the reinstatement period varies by state, with some states giving borrowers a mere five days to settle disputes and debts and others giving borrowers up to 90 days.
If the mortgage's unpaid balance is not paid off within three months, the homeowner receives a notice of sale. The property is then auctioned at a trustee sale to the highest bidder, who must pay in cash within 24 hours. The opening bid is usually equal to the outstanding loan balance and any additional attorney fees the bank may have incurred.
Here is a video that compares the process and impact of foreclosures to short sales based on five major criteria:
Short Sale Process
When the market value of the property is less than the outstanding mortgage principal, and the borrower cannot afford to pay the mortgage, the lender (one or more banks) may choose to accept a short sale. In a short sale, the proceeds from selling the property fall short of the mortgage balance, which is one reason lenders may be hesitant to accept a borrower's offer for a short sale. Any unpaid balance owed to the lenders after a short sale takes place is known as a deficiency. Short sale agreements do not necessarily release borrowers from their obligations to repay any deficiencies of the loans, unless specifically agreed to between the parties.
In a short sale, the homeowner puts the house on the market with a realtor. It is handled like any other home sale. Once the homeowner has accepted an offer, it must also be accepted by the bank. It can take anywhere from 3 to 6 months for a short sale to close, and its success is not guaranteed. However, the Federal Housing Finance Agency (FHFA) created new rules in 2012 that makes this process easier and faster. For example, mortgage lenders now have to respond to a short sale offer within 30 days of receiving it.
In August 2012, the FHFA announced measures to make short sales of underwater homes — homes where the outstanding mortgage is greater than the current market value of the home — easier for homeowners, including extending help to people who have financial difficulties but haven't missed mortgage payments. Under the plan, which went into effect in November 2012,only mortgages guaranteed by Fannie Mae and Freddie Mac are eligible for this help, and there is a $6,000 cap on the amount of money that holders of second mortgages can receive when a short sale is completed. This measure is meant to reduce the incentive holders of second mortgages have to haggle over their slice of the home-sale proceeds, thus avoiding delays and making it easier to complete the sale. The new rules also allow homeowners with missed mortgage payments and serious financial problems to submit fewer documents to be approved for a short sale. Homeowners receive speedier approval if they are experiencing a financial hardship such as a lost job, divorce, death in the family, or job relocation.
Complications for Buyers in Foreclosures vs Short Sales
Foreclosures and short sales offer deep discounts for buyers. Someone buying a house in a short sale can expect the home to cost 10% less than an ordinary home on the market;foreclosures are even cheaper,often by about 30%. However, these purchases are not without complications.
The most common problem with foreclosed properties is that they are often sold “as-is”, so the house may need repairs, which are sometimes very expensive. When a foreclosed property is purchased in an auction, the buyer must pay cash on the same day, which means they cannot get the property inspected, and therefore have no idea about the extent of repairs needed. Sometimes, the buyer of a foreclosed property may be required to pay unpaid property taxes from the previous owner. Finally, redemption laws allow borrowers to reclaim their foreclosed homes, even if the home was sold to a new buyer after foreclosure. This can cause many complications for buyers of foreclosed properties.
Short sale properties are also often bought for less than appraisal price. However, the process can be very time consuming. Buying a property in a short sale usually takes a lot longer because it's not just the buyer and the seller who have to agree to the sale. All the lenders that hold a lien on the property have to agree to the sale as well. If the first mortgage has been re-sold by the original lender, it may now be owned by multiple banks. If there is a second mortgage on the house, the lender(s) in the second mortgage also may be lienholders. Getting all lenders to approve a short sale takes time and could even prevent the deal from closing if a lender does not agree or if the seller can no longer make mortgage payments during the long wait (and therefore may get foreclosed upon). It takes 3 to 12 months to finalize most sales. Moreover, short sales are risky for buyers and sellers, as the bank can pull the house off the market at any point with no repercussions.
A foreclosure can cause a borrower's credit rating to fall by 200 to 400 points. It remains on a credit report for 7 years. This can have a very negative impact on future borrowing and even job opportunities, in cases where a potential employer requires a security check on all employees. Foreclosures are a part of one's public record.
A short sale can cause a drop of 50 to 130 points in one's credit score, although major reductions are usually due to the borrower being in default of the loan. Credit reports will state that a loan in a short sale was “settled,” “paid as agreed,” or “paid in less than full.”
After foreclosing on a house, an individual is eligible to buy another home in 5 years, with some restrictions, or in 7 years with no restrictions. Individuals must report the foreclosure on all future loan applications.
After a short sale, the individual may be able to purchase a new home immediately if their payments were never more than 30 days late and the lender does not require them to pay back the loan. However, finding a new lender may be difficult.
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