A preforeclosure sale, commonly referred to as a short sale, is the sale of a residential property in lieu of foreclosure for an amount less than what is owed on the mortgage. It’s one of those scenarios that should be stringently avoided, but nonetheless became more common after the economic downturn of the late 2000s. So, it’s important to understand if and how someone can again buy a home with a mortgage after having experienced a short sale.
First, let’s back up and look at what happens in a short sale scenario. During and just after the downturn we most often saw this happen when a homeowner/borrower got in financial distress, needed to sell their home, but could not get a sale price on the home to cover what was owed on it.
In such a circumstance, the homeowner/borrower would ask the servicer of the mortgage, in essence, “can we sell the home for this much and, in so doing, only pay X amount, rather than the full amount owed on the mortgage?” Obviously, banks and other lenders do not take such lightly, but often saw scenarios in which recovering part of what was owed on a mortgage was preferable to seeing it default in full. But, again, it’s important to note that a short sale must be pre-approved by the servicer of the mortgage.
A preforeclosure sale is indeed a derogatory credit event and thus impacts an individual’s ability to obtain a mortgage on a new property in two ways. First, the preforeclosure sale will significantly lower the individual’s mortgage credit score, potentially too low to qualify for a mortgage.
Second, typically there are waiting periods that must pass before an individual can obtain a residential mortgage again. The waiting period varies by the type of mortgage and whether or not there were extenuating circumstances, but standard waiting periods include:
- Conventional mortgage underwritten to Fannie Mae or Freddie Mac guidelines: 4 years.
- FHA mortgage. If no payments on the previous mortgage were 30 days late for the 12 months prior to the sale of the property and all other debt payments were made on time during that 12-month period – no waiting period. Otherwise, the waiting period is 3 years. It’s worth noting that an individual cannot obtain an FHA mortgage if the preforeclosure sale was pursued because the property’s value had fallen and a similar or superior property was purchased at a reduced price (compared to current market) within a reasonable commuting distance to the short-sold property.
- VA mortgage – 2 years.
- USDA mortgage – 3 years.
Extenuating circumstances may shorten the waiting period if they can be properly documented. Such circumstances are defined as those beyond the borrower’s control that result in a substantial and sustained decrease of income or increase of liabilities. These may include the death, serious illness or long-term disability of a primary wage earner; loss of job through no fault of the employee; large uninsured medical expenses for a spouse or child; etc. Divorce or the inability to sell the property due to a job transfer or relocation are not considered extenuating circumstances.
If extenuating circumstances can be proven, the waiting periods may be reduced, as follows:
- Conventional mortgage – 2 years.
- FHA mortgage – no waiting period if the borrower has re-established good credit since the sale.
- VA mortgage – 1 year if the borrower has re-established good credit since the sale.
- USDA mortgage – no waiting period if the borrower has re-established good credit since the sale.
The waiting period will increase to seven years if the individual has an additional derogatory event (bankruptcy, foreclosure, charge-off of a mortgage account, deed-in-lieu of foreclose, or a second preforeclosure sale) during the past seven years.
Jumbo loans are usually underwritten to Fannie Mae or Freddie Mac guidelines. However, since jumbos are not sold to those two entities, the borrower with a preforeclosure sale may need to wait seven years before obtaining a jumbo loan.
Even if the borrower cannot qualify for one of the loans described above, they may still be able to obtain a mortgage. Some lenders offer “fresh start” programs under which there is no waiting period required after a single derogatory event, such as a short sale. With the exception of the preforeclosure sale, the borrower’s credit history will need to be acceptable.
Typically, the borrower will need to make a down payment of at least 20% and can expect to pay a substantially higher interest rate than the current market rate for a similarly situated borrower without a derogatory event on his/her credit report. A higher interest rate is the result of the lender taking a greater risk on a borrower who has had past repayment issues.
There are many variables involved in any short-sale scenario and, likewise, in any subsequent lending opportunities afforded the borrower, but some other details to know include:
- The date assigned to the preforeclosure sale is the date that the sale/purchase closes, rather than the date that the current servicer agrees to the transaction.
- In escrow states (AZ, CA, NV, UT and WA), the date assigned to the preforeclosure sale is the recording date.
- And, although as noted above divorce is not generally considered among extenuating circumstances, an exception may be granted for a divorced individual if the mortgage involved in the preforeclosure sale was current at the time the divorce was granted; the ex-spouse received the property in the settlement agreement; and the ex-spouse subsequently sold the property through a preforeclosure sale.
- A second derogatory event in the last seven years may be acceptable under some programs.
- A short sale involving more than one mortgage provider – for instance, where there is both a first and a second mortgage involved – is likely more difficult to navigate both during and after the short sale.
To recap, a short sale is indeed a circumstance to be avoided, but given the economic challenges of the last few years, we have seen more of them. The best advice for navigating a potential home purchase after a short sale is to confer with a trusted mortgage professional who knows your individual circumstances, so you can re-enter the world of mortgages if and when the time is right for you.