Seller Qualifications for a Short Sale

With my first short sales in 1992, the seller had to be totally destitute to qualify with their bank for a short sale. If they had any money, or any way to get some money, they bank wanted it. If you were a bank, you would not want to let a borrower get away without paying you back unless there was no way they could pay you back.

Now, the qualifications are easier. Software has even been created to review the qualifications of a seller for a short sale. Just like Desktop Underwriter will review whether a borrower is qualified to receive a loan, this software will review the seller’s qualifications for a short sale.

The borrower cannot have sufficient assets to come to the closing with the money necessary to pay the loan in full. Some people say that the seller has to be insolvent. That is a bit stronger than necessary. The borrower does not have to be totally bankrupt, just unable to use any assets to raise the money to pay the balance due on the loan.

The second thing that will make it easier for the bank to approve the sale is if the seller has a negative cash flow. In other words, if the seller has less money coming in than what is going out, every month the seller is short of money to pay the household obligations. This is where some sellers will hurt themselves. Most people are used to filling out financial statements to make themselves look good. They have a hard time facing their financial problems so they will fill out their financial statement to show that they balance each month i.e. the same amount of money comes in as goes out. Encourage the sellers to be honest, if they are financially losing ground every month, put it down that way.

The third thing the lenders look for is financial hardship. The hardship letter is discussed in detail in a separate post. You want to show a reason for a change in the financial situation from when the loan was originated to the present. So, if the sellers lost a job, watched their business fail, had the mortgage payments adjust, had a family tragedy or had a medical problem, show the financial consequences of the hardship.

Having poor credit is a problem for getting a loan. Having poor credit is no problem for getting a short sale. Do not worry that the credit is bad. It should be if there is serious financial distress. But, bad credit is not a requirement for a short sale, as I have done a number of short sales for people who have made every payment right on time.

Qualifying for a short sale is the reverse of qualifying for a loan. To get the loan, you have to show that you have a positive cash flow, plenty of assets in reserve and no financial problems. To get a short sale, you have to show a negative cash flow, minimal assets and serious financial problems.

Short Sale’s Effect on Credit

There are people who say that a short sale does not have a derogatory effect on your credit. I disagree. I have minimized the effect for some of my clients and on rare occasions convinced the bank to report the sale as “paid as agreed”.  That is extremely rare.  Normally, a short sale is reported as “paid for less than full value”.  That is a substantial ding on the seller’s credit. 

My friend George Durkin from Las Vegas is a great student of short sales.  He sent me an article from About.com that argues that a short sale is not much different than a foreclosure as far as a future lender is concerned, because both show that the borrower did not pay the loan fully.  It argues that the next banker will look at the short sale on the credit report and say “that the defaulting homeowner is someone who, when the chips are down, didn’t honor a contract.”   I disagree with that also, and I think George does too, but he knows I want to read everthing on short sales.

While the effect of a short sale on a credit report is not good, it is not as bad as some of the other choices.  The simplest proof is to look at the Fannie Mae guidelines for loans.  The guidelines state  that the “seasoning” on a foreclosure is at least 5 years, the “seasoning” on a deed in lieu of foreclosure is 4 years, while the “seasoning” on a short sale is 2 years.   In other words, it will take five years if you are lucky after a foreclosure to qualify for top quality financing, four years after a deed in lieu of foreclosure to the the best loans,  while it takes two years to get back into good graces after a short sale.   There are some restrictions that apply to people with foreclosures that extend from the fifth year after the sale to seven years after the sale, such as Fannie Mae will not finance a second home during that period.  There are no such restrictions to people who have done a short sale.  

 Secondly, on a loan application the borrower will have to answer the questions in the Declarations Section VIII  “have you had property foreclosed upon or given title or a deed in lieu thereof within the last 7 years?  (y/n)”  The next question is “have you directly or indirectly been obligated on any loan which resulted in foreclosure, transfer of title in lieu of foreclosure,  or judgment? (y/n)”  If you have had a foreclosure or given a deed in lieu of foreclosure, you answer yes.  If you have had a short sale, you answer no.

Some commentators state that a foreclosure will cause a 250 point decline in your FICO score while a short sale will cause a 100 point decrease in the FICO score.   I do not believe you can measure it that precisely, as credit reports have many factors that are considered simultaneously.    Others say the range is from a 50 point decline on the low side to a 350 point decline on the high side, depending on what your score was before the short sale.  The short sale will drop of the credit scoring system after 7 years, which is normal for a derogatory item on a credit report.

On one hand some lenders argue that there is no credit preservation advantage of a short sale, and on the other hand there are those short sale commnetators who say a short sale has no effect on your credit.  Both extremes are not supported by the facts.  Like most other things in life, reality is somewhere in the middle:  there will be credit damage from a short sale, but it is better than the alternatives.