So you’ve heard of this fancy phrase “short sale” a lot more frequently lately, eh? Do you understand what the phrase means? Are you considering a short sale? Should you be? This blog is designed to provide exactly the kind of guidance for you to answer these questions appropriately.
First, let’s talk basics. A “short sale” is a sale of real property where the lender (i.e. the entity your mortgage checks go to) accepts less than is owed on your mortgage. So, for instance, let’s assume your mortgage balance right now is $300,000. If you sell your property for $300,000, you’ll most likely have closing costs of about $30,000 (or roughly 10% of the contract price). The left-over balance - in this case $270,000 (the $300,000 less the $30,000 in closing costs) - will be paid to the lender in complete satisfaction of your mortgage. Since this is LESS than you owe, the sale is called a “short sale.”
If you can fully satisfy the amounts owed on your mortgage, you do not have a short sale - a short sale only occurs when the lender accepts less than the amount owed.
Here’s a math equation describing the above:
Offer Price: $300,000
Closing Costs: $30,000
Net Proceeds: $270,000
You owe (your mortgage balance): $300,000
But you’re only going to give the bank: $270,000
Which means they’re losing: $30,000
(We call this a “DEFICIENCY“)
Since they’re accepting less than is owed, the sale is considered a “short sale.”
Is this a problem for the bank? Well, in reality, the bank has already created a “loss reserve” that projects what they expect to lose on this specific loan. The loss reserve will be based on all sorts of factors - and if you gave different banks the same loan details, they would likely generate different “loss reserves” for that same loan. The loss reserve offsets the value of their loan portfolio on their balance sheet, and attempts to create an honest prediction of the value of the loan.
Think of it this way: You have a friend Adam. Adam has a steady job, doesn’t spend excessively, but really wants to buy this spectacular new mountain bike that costs a whole bunch of money. You loan him $5,000. You ask him to repay it in 6 months. Your expectation is that Adam will repay the amount owed.
In contrast, your friend Billy works off-and-on, has a tendency to buy drinks for the entire bar on Friday night, and is generally unreliable. He asks for the same $5,000. You are kind-hearted, so you lend him the money, with a demand that he repay the amounts in 6 months. Do you expect to be repaid in full? Perhaps. But it’s fairly likely that you won’t be surprised when Billy comes to you and says he can’t make the payment. Or maybe he says he can pay $4,000. You have likely already adjusted your expectations for the possibility that Billy will not repay the entire amounts owed. The difference between the $5,000 and what you subjectively expect to receive is no different - in theory - as the bank’s “loss reserve.”
Loan losses are a cost of doing business to banks. When the risks look right (according to the bank’s actuarial specialists and risk-management people), and the bank’s loans are diversified amongst multiple risk “pools,” then the bank makes enough money to survive - to thrive even. But when the you-know-what hits the fan (like right now), and the bank’s projected losses pale in comparison to their actual losses, then the bank has a serious problem. A large number of short sales or foreclosures is a clear symptom of this problem.
Overwhelming loan losses can cripple banks, since they rely on monthly mortgage payments for their own operating capital. When you don’t pay your loan, this likely trickles down, leaving your lender in a troublesome spot to pay their own expenses.
Are you a candidate for a short sale? If so, keep reading the posts on this blog. We have helped multiple clients navigate these tricky waters.