A short sale is the transfer of ownership of a property in which the creditors secured by the property are paid off less than what they are owed. This happens when the value of the property is less than the value of the debt secured by the subject property and the owner can't make up the difference. Reluctantly, the lender forgives the unpaid balance. This article briefly explains why this happens.
The vast majority of properties are purchased with the aid of financing. In order to pay for the property, the homeowner places a small down payment. Since the down payment is not sufficient to purchase the property, a loan provided by a lender is used to pay the remainder of the acquisition value. In other words, the homeowner finances part of the purchase value of the property with a loan from a lender. To guarantee that the lender will get paid, the homeowner pledges the property as collateral to secure the debt payment. Thus, the lender is secured by the property. A mortgage is contract between a homeowner and a lender, in which the homeowner pledges his home as collateral to the home loan.
As time passes, if the payments are timely, the loan payoff value will incrementally diminish until the debt disappears. That is called amortization. The longer the homeowner keeps up with the payments, the more amortized the loan becomes. A fully amortized loan is a loan with zero balance. It is fully paid off. On the other hand, if payments are missed, the loan value, because of interest, will grow. That is called accrual.
When the homeowner sells the property, unless the home loan fully amortized, the secured lender needs to be paid off the unpaid balance. If the value of the property is sufficiently high, the proceeds of the sale will be sufficient for the home loan to be paid off and the homeowner to earn a profit or break even. If not, there will be a shortfall. To make up for this shortfall, either the homeowner will have to make up for the amount needed to pay off the loan, or the creditor will have to take less than the amount owed.
The value of a home loan is higher than the market value of the property if the market value of the property has diminished, the loan has accrued interest because of missed payments or the homeowner paid too much for the property. A property worth less than what is owed on the property is called an over-mortgaged property.
Homeowners with over-mortgaged properties are often unable to make up for the shortfall needed to pay off the home loan. If they are insolvent and default, matters get worse. The value of the home loan begins to accrue, getting bigger and bigger on a daily basis. Unpaid property taxes, utilities, and other costs also accumulate. When this happens, maintenance is often deferred. This results in further loss of value.
Once this happens, matters will only get worse. Urgently, the lender needs to recover as much of the debt as possible. Lenders in this situation have only two alternatives. One of them is to foreclose. The other is to allow the homeowner to sell the property for less than what they are owed. Either way, the creditor will take a loss.
Unless the property value is high enough, a lender that decides to foreclose only stands to lose. Only cash in hand investors looking for great deals buy at foreclosure sales. If the property is not sold at a significant enough discount, the creditor will have to keep the property. If this happens, the creditor will be liable for maintaining the property, insuring it, paying taxes, as well as all other costs. Not only that, to sell it, the lender will have to pay commissions!
A less risky alternative is to allow the insolvent homeowner to sell the property for less than what the lender is owed, get paid off now, and forgive any debt shortfall. This is a short sale. The lender gets paid less than what is owed and the homeowner is forgiven the remainder of the debt.
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