Will I be forgiven of the deficiency in a short sale?
Facing a financial struggle can be a really challenging part in any individual’s life, especially if it was due to any number of hardships beyond the individual’s control such as the loss of employment, death of a family member, divorce, or any other difficult changes in ones financial situation. One of the most demanding financial obligations that any individual has are mortgage payments, and any blow to the financial capabilities of the individual can directly affect how he or she handles their mortgage payments.
Financial obligations aside, if any homeowner however is forced to neglect or simply cannot afford the the monthly financial obligation that he or she has on their mortgage, there are only a number of options that he or she is left with. Foreclosure or short sale the home are the two most common for a borrower who must be relieved of their monthly financial obligations. These two options are not the only options available for a delinquent homeowner, but these are two of the easiest and most effective ways that can be taken especially if the homeowner has no other options available. But these two options also have a really large drawback in the form of a deficiency.
So a homeowner can in fact opt for the above mentioned options when it comes to their property, but throwing the deficiency factor in the mix begs the question: “Will I be forgiven of the deficiency in a short sale or in a foreclosure of my home by the lender?”
What are deficiencies?
Deficiencies are merely the difference in the homeowner’s owed mortgage debt to the lender as a result of selling a short sale home or a foreclosed property. Basically, selling a short sale or allowing your home to be foreclosed effectively decreases the value of your property as compared to the original mortgage payment, therefore resulting in the difference of amount that the homeowner still needs to pay to the lender. While the main differences between a foreclosure and short sale is clearly felt on the individual’s credit score rating (which can affect the relationship of the individual to banks, lenders, and shows up on the credit of the individual which might affect his employment status etc.), there are some differences to note with regards to each method’s deficiencies and the pros and cons for each that the homeowner might need to know to effectively determine whether to go for the short sale of a home or allowing it to go to foreclosure. In many states, a lender can't legally pursue collection of the deficiency in a short sale or foreclosure. The first step for any borrower in hardship to do is to determine if they are in a recourse or non recourse state. In many states or in many cases, a borrower simply forfeits the property, suffers the negative credit impact of a short sale or foreclosure, and moves on with their lives. For those who may still be liable for the deficiency, simply walking away and allowing a foreclosure can permanently scar ones credit and financial future.
Terms of a short-sale and a foreclosure deficiency
In order for us to properly determine the pros and cons of a short sale and a foreclosed property in terms of deficiencies, it is important to properly identify the terms:
- Short Sale deficiency terms – deficiencies in selling a short sale home happens when the transaction does not produce the necessary funds enough to cover the mortgage debt in full. There are a lot of ways to settle a short-sale deficiency, and they can be any of the following:
- I. Waived – the lender allows the homeowner to exchange a payoff or immediatesettlement of the balance to cover the mortgage debt in full. This is the most common practice in a short sale transaction. A good, experienced short sale Realtor presenting a valid hardship only increase the chances of complete forgiveness.
- II. Promissory note – The lender allows the homeowner to sign a new note promising to pay an agreed upon amount. This is very common in the event of Mortgage Insurance, and will typically be a set amount such as $10,000 or $20,000. These will also many times list the actual dollar amount due with each monthly payment.
- III. Unsecured notes – An unsecured note is sometimes referred to as a "soft" short sale. In this type of short sale, a lender will basically release the lien from the property and allow the short sale to take place, credit all proceeds from the sale towards the principle balance, and leave to borrower responsible for the remaining balance after closing. These are most common with second loans, or in situations where the borrower still has other assets or income.
Both promissory notes and unsecured notes/balances are both typically considered unsecured debt. Because there is no asset actually securing these loans, once defaulted they are typically settled for 10-20 cents on the dollar. A $20,000 note can be many times be settled for no more than $2,000-$4,000. A borrower faced with the possibility of a promissory note or a soft short sale should also consider the fact that many times the notes are never even collected on. A classic and common case of the left hand not knowing what the right hand is doing.
For any actual money forgiven, the Mortgage Forgiveness Debt Relief Act of 2007 comes into play, because any form of unsecured note by the homeowner that is not claimed by the lender falls under 1099 tax on sale substitution that the lender is in charge of. This act allows a borrower to be forgiven of the deficiency without being liable for paying taxes on the deficiency. Of course, consult the appropriate legal representation and guidance in all tax and legal matters.
- Foreclosure deficiency terms – because the foreclosure is a legal action that is taken by the lender as a result of the homeowner being negligent and late when it comes to settling the payments for the mortgage resulting in the default transfer of the property back to the lender, a foreclosure deficiency is a legal action towards the homeowner by the lender – or in other words the homeowner is being legally sued by the lender. This action is known in legal terms as Judicial Foreclosure, or the legal action taken by the lender in which they sue you for the difference in amount of the mortgage not covered by the foreclosure sale. Facing public humiliation because of property foreclosure is bad enough, but being confronted with a legal action that will definitely show up in your public and credit records should definitely convince any homeowner to choose to at least attempt a short sale on their home rather than face foreclosure. One thing that any individual might consider Judicial Foreclosure might result in the homeowner not being allowed for any kind of mortgage loans for a minimum of 5 years. A borrower can typically qualify for a loan only two years after completing a short sale.
A truth that is rarely discussed is that deficiency judgments are rarely pursued in a foreclosure. Fannie Mae's practice is to only go after the borrower in extreme circumstances where the borrower has other assets. Despite our financial institutions poor judgment in giving many of these mortgage loans to begin with, most are savvy enough to realize that you can't get blood from a turnip.
So to summarize and to answer the earlier question of: “Will I be forgiven of the deficiency in a short sale?”, the short answer is "who knows". Considering the potential risks involved in both options, any homeowner is definitely encouraged to at least attempt a short sale. While there are uncertainties when it comes to either option, two certainties are that the recovery period of a short sale on credit and future purchasing is much quicker when compared to a foreclosure, and a short sale is not public record. As has been clearly stated by the terms and benefits above, it is also much easier to settle a deficiency occurred when you short sale a home because you can settle the deficiencies with a lender through settlements of your own choosing instead of being forced by legal action. By choosing the terms by which a homeowner can settle his or her debt, the legal battle that can certainly affect the homeowner’s public record and credit score can be minimized.