How does a short sale work?

Buying a home through a short sale is similar to buying a foreclosure, but the two processes aren’t the same.

In a short sale, the bank or mortgage lender does not evict the homeowner. Instead, the lender lets the current owner sell the house for less than their mortgage debt.

The benefit of buying a short sale is that you could find a home at a reduced price.

But the process can often be time-consuming and frustrating, and short-sale transactions have unique perils. Plus, there’s no guarantee you’d save money compared to a traditional sale.

Here’s what you need to know if you’re considering buying a short sale home.

In this article (Skip to…) 

• What is a short sale?
• The short sale process
• How long does a short sale take?
• Obstacles during the short sale process
• Who should buy a short sale?
• Pros and cons of buying a short sale

What is a short sale?

A short sale transaction can happen when a homeowner’s mortgage loan balance exceeds their home’s market value.

In other words, the home’s market value falls short of the balance owed on the mortgage. This is also called being “underwater” or in “negative equity.”

In a short sale, the homeowner needs to sell his or her underwater home — and the mortgage lender gives permission for the property to be sold for less than the outstanding balance.

The lender will lose money, but it agrees to the sale of the property in order to avoid the foreclosure process, which could cost even more.

In a way, a short sale can help both the lender and the homeowner. And it also helps you, the home buyer, if you can get a below-market deal on the property.

The short sale process

The short sale process is a lot like buying a home off the market.

You’ll start by finding a house and getting pre-approved for financing (unless you’re paying in cash). Then you’ll make an offer, negotiate the sale, and close.

But at any of these stages, there are unique challenges for short sale homes. Here’s what you need to know.

Step 1: Find a short sale home

Given the complexity and risk associated with short sales, we don’t recommend going it alone unless you have plenty of prior experience.

Although you could search for properties on your own using a Multiple Listing Service (MLS), it’s better to hire a real estate agent who is experienced in short sales.

A good agent will check the title, learn whether a foreclosure notice has been filed, and determine how much is owed to the lender(s). This data will help you prepare a competitive offer.

In addition, the agent will help you negotiate the best deal and overcome any roadblocks to a successful closing.

Be aware the short sale process could take much longer than a traditional home purchase. Even with a qualified agent, it’s not uncommon for short sale transactions to take six months or more to close.

Step 2: Get pre-approved for financing

Unless you’re paying for a short sale property with cash, your first step is to get pre-approved for a mortgage.

This is a must. Without financing in place, a bank is likely to dismiss your offer out of hand.

Luckily, getting pre-approved is relatively fast and easy.

Many lenders can verify your credit score and financial documents in just one day. Then they’ll write you a pre-approval letter, which gives you the power to make a credible offer on a home.

Step 3: Make an offer

Your third step to buying a short sale home is to make a competitive offer. Although you may be able to buy below sticker price, don’t count on it. Instead, make a reasonable offer based on the home’s value.

A real estate agent who knows your local housing market can show you comparable properties (“comps”) that have recently sold, so you can make a realistic offer.

A good offer package for a short sale will include:

• A purchase contract for you and the seller to sign
• An earnest money deposit. A substantial deposit shows the listing agent and bank you are a serious buyer. If the deal closes, the deposit becomes part of your down payment
• A pre-approval letter to prove you have the ability to purchase the property at the offered price
• Information on recent sale prices for similar properties in the area (“comps”) to prove your proposed price is reality-based
• Proof of funds — This may be needed if a pre-approval letter doesn’t convince the seller you have enough money. Proof of funds can include copies of bank statements, as well as equity lines of credit and certified financial statements

Launching the negotiations with a low-ball offer is not likely to work out in your favor. A lender can dismiss your offer without even responding.

Making low-ball offers might have worked during the last recession when lenders were desperate to mitigate their losses. But sellers can afford to be more discerning now.

In fact, underpricing is the number one reason banks reject short sale offers.

Another common reason for rejection is an incomplete offer — one that doesn’t contain all the necessary documents.

So make sure you have your paperwork in order before attempting to buy a short sale home, just like you would for any other home purchase.

Step 4: Negotiate the short sale and contingencies

You and your agent should also prepare a short sale addendum with certain contingencies.

“Contingencies” are conditions that have to be met before the home sale will go through.

For example, you probably want to make your offer contingent on the lenders’ approval of the sale, the length of time you’re willing to wait for short sale approval, and the amount you will pay in closing costs.

You probably also want a short sale to be contingent on the results of a home inspection.

Whatever you do, don’t buy a short sale home without having the place inspected first.

In fact, you may want to hire specialized inspectors to look for pricey problems such as termites, mold and structural damage.

Note: Short sale homes are sold “as is”

Keep in mind that a short sale is an “as-is” purchase.

Unlike regular home sales, you should not expect the seller to lower the asking price if your home inspection uncovers problems. It rarely happens.

But an inspection can still uncover deal-breaker issues that might turn you off from buying the home.

If you’re a smart and determined buyer, it’s possible to find short sale bargains. Once you find one, a successful outcome can definitely be worth the effort.

How long does a short sale take?

One California-based agent has estimated it takes about 60 to 90 days on average for a lender to approve a short sale deal — and that’s after receiving the full offer.

However, that’s just one agent’s estimate. The actual time frame for a short sale can vary a lot.

The time to close depends on where you live. It could be way longer if multiple lenders are involved. And 60-90 days is just an average, meaning by definition that some take less time and others more.

The variables are just so wide and complex that a real estate agent who specializes in short sales could only guesstimate the time from offer to closing — even if they were in full possession of the facts of your case.

Obstacles to expect during the short sale process

Three common obstacles can make a short sale take longer than a traditional sale — or prevent the transaction altogether.

1. Multiple debts are owed. If the homeowner borrowed from multiple lenders, the “junior lien holders” might block the sale. These lenders often receive little (or no) money from short sales. An example would be a home equity lender that secured debt against the home after the original mortgage was taken out
2. The seller could cancel the deal. This sometimes happens when the primary lender asks the seller to contribute to the closing costs and the seller balks
3. The bank accepts a competing offer. This can happen even after you make an earnest money deposit and pay for a title search, home inspection, etc.

Because of these unique pitfalls, it’s especially important to know what you’re getting into when you start the short sale process. And you’ll most likely want an expert, like an experienced real estate agent, on your side.

Who should buy a short sale home?

There are often challenges and delays when buying a short sale home — which is why a disproportionate number of short sales are taken up by professional property developers and house-flippers.

These potential buyers are not emotionally invested in the transaction and can shrug off delays right up until they pay the purchase price and take possession. They may not care much even if the deal falls apart if they have multiple others in the pipeline.

It’s different for individual home buyers who are looking for somewhere to live, because they could be in a sticky situation if the sale falls through.

Maybe you’re well-situated to wait out a short sale, and these pitfalls wouldn’t pose a challenge for you. But there’s a good reason so many private buyers leave short sales to the pros.

Pros and cons of buying a short sale home

The biggest benefit to buying a short sale home is the chance of finding a great deal.

And unlike with a foreclosure, a short sale home is likely to be in good condition. Often, the current owner will be still in residence and keeping up basic maintenance. A foreclosure, by contrast, might be in disrepair.

Many challenges in the short sale process stem from one fact: the homeowner isn’t making the decisions about the short sale transaction.

It’s the mortgage lender that holds the home and supervises the sale. There could even be multiple lenders if the current owner has a second mortgage, such as a home equity loan or home equity line of credit (HELOC).

Some home buyers choose to put up with short sale complications because they could buy at a bargain price. But you should be fully aware of the potential issues before considering a short sale purchase.

Short sale homes can be hard to find

In order to need a short sale, a homeowner must have negative equity — meaning the home’s mortgage balance is higher than the property’s value.

After the housing market collapse that started back in 2008, a lot of homeowners found themselves underwater on their mortgages. This meant a lot more homeowners qualified for short sales.

The situation has changed dramatically since then. Home values have bounced back and continue to grow in most markets. Now, with interest rates so low, more homeowners in trouble can afford to keep their homes by refinancing.

To qualify for a short sale, a homeowner must also prove financial hardship. A seller may even need a hardship letter or pay stubs proving he or she can’t possibly catch up on mortgage payments and avoid becoming an REO property (foreclosure).

Dr. Frank Nothaft is chief economist for CoreLogic, a company that tracks property markets and mortgages. He explains: “Ten years ago, during the depths of the Great Recession, more than 11 million homeowners had negative equity or 25% of mortgaged homes.”

But, “After more than eight years of rising home prices and employment growth, underwater owners have been slashed to just 2 million, or less than 4% of mortgaged homes.”

So today there are way fewer opportunities than there once were for savvy buyers to take advantage of short sales.

Still, those opportunities haven’t dried up completely. For determined buyers, there could still be good deals to be found.

The short sale process can have long delays

Short sales are often given lower priority than traditional sales. That’s because the paperwork is being processed by a lender that knows it’s already lost money on the home.

Sometimes it takes weeks or even months for a short sale offer to be accepted or rejected. Or the lender may make a counteroffer, in which case you can refuse, accept, or counter back — which involves restarting the process from square one.

If second mortgage lenders or ‘junior lien holders’ are involved, delays may be stretched beyond endurance as they each need to buy into the deal.

The National Association of Realtors describes some of its members’ experiences with short sales:

“As a result of these challenges our members have reported difficulties with: unresponsive lenders; lost documents that require multiple submissions, inaccurate or unrealistic home value assessments, and long processing delays, which cause buyers to walk away.”

That’s not to say everyone will have such a painful experience buying a short sale, but it is important to set your expectations realistically.

Buying a short sale will likely be more difficult than buying a house off the market would be.

What happens to the original homeowner after a short sale is closed?

For the home’s seller, a short sale signifies the end of a long and stressful journey. Homeownership didn’t go as planned. The owner couldn’t afford the mortgage payments either because of a job loss, illness, or some other unplanned circumstance.

The owner may have tried to refinance but couldn’t, either because of credit report problems or a lack of income. The original homeowner may have applied, unsuccessfully, for loan modification programs.

To avoid losing the home through foreclosure, the owner successfully appealed to the lender for a short sale transaction. But in doing so, he or she lost control of the selling process and any ability to ever reclaim the down payment or any additional equity.

The lender’s loss mitigation department now calls the shots instead.

After a short sale, the lender may forgive the entire debt even though the sale’s proceeds didn’t pay off the entire mortgage loan.

Other times, the lender may pursue a deficiency judgment against the borrower through the courts in an effort to recover the shortfall. A homeowner who asks for a short sale should try to get a waiver to prevent the lender from trying to recover the lost money in the future.

The homeowner’s credit will be wrecked for a time, but it will typically recover more quickly after a short sale than after a foreclosure.

For example, a homeowner who relinquishes the home through a short sale process can buy another home through the FHA loan program whenever he or she meets the lender’s underwriting criteria.

After a foreclosure, though, FHA requires a three-year waiting period before buying another home. Conventional loans backed by Freddie Mac and Fannie Mae require a seven-year wait for borrowers with a foreclosure on their credit report.

Is buying a short sale worth it?

For now, the days of easy pickings from short sales are over. Homes in pre-foreclosure and foreclosed bargains are getting harder to find, too.

True, you can still find very profitable deals with a short sale. But you have to work harder and smarter to hunt them down.

And it’s strongly recommended that you work with a professional agent who has plenty of short sale experience.

If you’re interested in buying a short sale home, you still need to get pre-approved for financing. That step, at least, you can start right here.