As a homeowner facing foreclosure, you may have been advised to sell your home via a short sale. Many people think it is the best way to escape foreclosure. They will tell you that it will do less damage to your credit score than a foreclosure. Or point out that it helps homeowners escape the stigma associated with losing their home to the bank.
But the truth is that a short sale may be a bad option for a homeowner facing foreclosure. It may even end up doing them more harm than good.
However, don’t just take our word for it. Follow us as we show you why a short sale may not be right for homeowners in foreclosure.
What is a short sale?
A short sale happens when a borrower gets the lender’s approval to sell their house for less than the debt owed. Homeowners usually choose this option in the hope that their lender will forgive the rest of the loan.
Before approving a short sale, the lender will require proof of financial difficulties. After that, the borrower will need to find a buyer for the house. Once the lender approves this buyer’s offer, the deal is sealed.
While this process looks simple enough, there are a lot of drawbacks that come with it, such as:
1. You have to prepare your home for sale
You are facing foreclosure in the first place because you ran into financial trouble. Needless to say, you don’t have that extra cash lying around for home repairs. But as with traditional home sales, before listing your home for a short sale, you have to improve it.
Not improving your home can mean one of two things: you won’t attract any serious buyers, or buyers may not be able to get a bank loan to purchase your home. Each scenario puts you in a more terrible situation.
Hence, the first problem with a short sale is getting money to prepare your home for the market. But it does not end there.
2. Short sales take time
You must consult your lender and wait for their approval before you proceed with the short sale. This wait takes months, and there is no guarantee that your lender will accept your proposal.
If they approve your offer, you will list your home on the market to get a buyer. After that, you need the lender to approve that buyer’s offer. This whole process takes an average of four months to complete, which is quite lengthy. To put this into perspective, the average traditional home sale process takes just over two months.
During that long wait, it’s common for potential buyers to drop out, requiring you to start the process all over again. Some lenders will even intentionally create delays to cause buyers to back out if the lender decides that foreclosure will be less expensive for them than a short sale.
Even if you manage to get through the whole approval process, there is another problem.
3. Your lender may not forgive the outstanding debt
The primary reason a homeowner facing foreclosure will choose a short sale is that it offers them a chance to move on quickly. They believe the lender will forgive the outstanding loan. But that is not how it works every time.
You see, in some cases, the bank does not forgo the remaining balance. This often happens if your house sells for far less than you owe. In a situation like this, the lender files for what we call a delinquent judgment.
In case you don’t know, a delinquency judgment is a ruling by a court against a debtor. It happens when the debtor’s property’s sale does not produce enough money to pay their outstanding loan. This judgment usually leads to an agreement by the debtor to pay the lender.
If the debtor refuses to pay, the lender may sue them. Consequently, the court will take the debtor’s property (called a “levy”) or order their employer to pay with a percentage of their wages (called a “garnishment”). So, even after selling your home via short sale, you are not guaranteed the freedom you crave.
4. After-sale tax
Now let’s assume that your lender agreed to the short sale and also forgave your outstanding debt; what happens next? Well, you must report the forgiven debt on your tax return. And the IRS will tax you for that because it counts as income. Imagine suddenly being faced with taxes on several hundred thousand dollars of “income” from the forgiven debt. Taxes like that can force people into bankruptcy.
The law may allow you to exclude this detail from your tax returns in some cases, so we recommend that you consult with a qualified CPA who is familiar with short sales when considering the potential tax impact.
5. Negative impact on your credit score
A short sale may not damage your credit score as much as a foreclosure, but it will still leave its mark.
According to experts, a short sale can affect your credit score by over 160 points. However, how it affects your credit score depends on how high your point is. The higher the point, the more significant the damage.
Also, the average recovery rate for a short sale credit point is seven years. You may not be able to get another mortgage loan to purchase a new home within this recovery period. Even if you get a new loan, the interest rate will be high.
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