What is a short sale? It is a sale that occurs when an existing mortgage lender agrees to accept payment that is less than what is currently due under the promissory note the homeowner originally signed at the closing (thus falling "short" of the total amount the homeowner owes).

The promissory note represents the homeowner’s contractual obligation to repay the loan. The mortgage is the security interest in the property if the homeowner does not make payment according to the terms of the promissory note. If the homeowner does not make payments, the bank can enforce its security interest, repossess the house through foreclosure and sell it at auction.

Why Short Sale?

Banks are not in the business of owning property and foreclosure is often a losing situation for everyone involved. A mortgage lender might agree this type of sale when the time and expense of a foreclosure proceeding, and selling the property at auction, is not a more profitable alternative. At a foreclosure sale, a home will usually sell for pennies on the dollar. In many situations, therefore, it is in the lender's best interest to approve the transaction.

How to avoid Foreclosure

Some of the factors that make it more likely that a mortgage lender will agree to accept less than what is currently owed include:

• The homeowner is unable to make payments as evidenced by at least two months of missed mortgage payments (you have a legal obligation to make payments if you have the means).
• The homeowner’s default is due to an unavoidable hardship that can be adequately documented and described for the mortgage lender.
• The homeowner’s hardship is likely to endure for the foreseeable future.
• The mortgage in default was obtained within the last five years.
• The homeowner uses the property as a residence, and not as a vacation home or investment property.
• The homeowner was provided a loan with unfair terms.
• The real estate appraises for at least 75% of the unpaid balance of the first mortgage.
• The contract price is for about 95% of the appraised value.
• The net amount due to the lender on the HUD Settlement Statement, after all closing expenses, is at least 87% of the appraised value.

How to Short Sale

Keep in mind that the process will normally take about two to four months to complete but can take even longer in some instances. It is important to plan for this extended time frame and set realistic dates from the very beginning. Typical steps include the following:

• Hiring both an attorney to help you navigate the process and a certified public accountant to determine whether any adverse tax consequences could result. Forgiven debt can constitute income under IRS guidelines.
• Having your Realtor determine the fair market price and begin listing the property.
• Obtaining your lender’s approval package from its loss mitigation department(which sometimes is also referred to as "home retention department") and beginning to assemble the necessary information with your real estate attorney and realtor.
• Receiving an offer on the property to provide to your lawyer so that it can be submitted to your mortgage lender with any other required documents.
• The lender then conducts an appraisal and verifies whether the offering price is reasonable. If not, more substantial negotiations will ensue and a cash payout over a certain number of years after the closing may be required.
• The transaction is approved in writing by the mortgage lender and a letter is ideally provided stating that the lender will not pursue a deficiency judgment against the owner (not all lenders will state that they will not pursue a deficiency action and may leave leave this open ended).

Preparing the Approval Packet

You will need to submit all of the following documents to your lender:

• A signed letter from the homeowner authorizing his or her attorney (and/or real estate agent) to communicate with each mortgage lender. The letter should include the owner's name, property address, social security numbers, loan number, and contact information for the seller’s attorney.
• A preliminary HUD-1 Settlement Statement which provides a breakdown of all the estimated closing costs that will be deducted from the lender’s proceeds at closing.
• A letter stating the reason for the unavoidable hardship that led to the default, and a request for the mortgage lender to accept less than what is currently owed on the loan. Some examples of unavoidable hardships might include death or illness within the family, job relocation or loss of employment income, divorce or separation, or adjustments in mortgage payments.
• Proof of income and assets will need to be provided in the form of original pay stubs, bank account statements (usually 2 to 4 months), tax returns, W-2 forms, and 1099 forms. 
• The comparative market analysis showing pending and recent sales of similar homes in the area will need to be prepared and submitted by your real estate broker.
• A copy of the Offer to Purchase and Listing Agreement. The lender might require you to make a counter offer or renegotiate other terms, fees, commissions, etc., if the asking price is too low.

Effect of a Short Sale on a Credit Report

One of the biggest misconceptions is that a homeowner's credit report will not be affected. This is not the case. A homeowner can expect a loss of at least 100 - 200 points on their credit report after the transaction which is generally less than would be expected from a foreclosure proceeding (between 200 and 300 points) or bankruptcy. Another benefit is that the waiting period to buy another home is typically shorter.