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How to buy from sinking homeowners

Today's tough market is encouraging more short sales, in which sellers avoid foreclosure and lenders OK reduced mortgage payoffs. For buyers, there are both deals and pitfalls.

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By Bankrate.com

There are few active buyers in the real-estate market these days, but every one of them seems to be looking to buy a foreclosure or a short sale.

Foreclosure is a fairly well-understood process, but as "short-sale" signs sprout like weeds, you may wonder what they're all about.

When a lender agrees to accept a mortgage payoff amount less than what is owed in order to facilitate a sale of the property by a financially distressed owner, it's called a short sale. The lender forgives the remaining balance of the loan.

Everyone loses -- a little

Short sales are a mixed bag for the buyer, the seller and the lender.

If you're a seller, a short sale is likely to damage your credit, but not as badly as a foreclosure. You'll also walk away from your home without a penny from the deal, possibly making it difficult for you to find another place to live.

The buyer will get the property at a reduced price, but in all likelihood it will have its share of problems (think fixer-upper), and the new owner will need to go through considerable red tape to make the deal happen.

The lender will take a financial loss but perhaps not as large as it would have if it had foreclosed on the property.

Further, there are two situations in which an attempt at a short sale is almost certain to fail:

  • No default on loan. Lenders almost never will accept short-sale offers or requests for short sales until the borrower is far behind in payments and a notice of default has been issued.

  • Bankruptcy. If the seller has filed for bankruptcy, forget it. Few, if any, lenders will consider a short sale when the seller has filed for bankruptcy because negotiating a short sale is considered a collection activity, and collection activities are prohibited in bankruptcies.

Can it work for you?

Buying a home in a short sale can be a hassle, so why should you consider it? Mainly, it boils down to the bottom line. You can get the property for a substantial discount. Because the lender is eager to get back as much of the money it lent out as it can, you may also get favorable financing terms.

Because sellers play an active role in the short-sale process, you will have their cooperation (and most likely won't need to evict them upon taking possession of the home). This is not always the case with a property that has gone through foreclosure.

You may have become aware of the distressed situation on a property through an agent, a for-sale-by-owner ad or word of mouth, but this is not a do-it-yourself project. A short sale is one real-estate deal where you really need help from an experienced agent or attorney. Not all real-estate agents know how to handle a short sale, so make sure you consult with one who can demonstrate special training or a good track record with short sales.

Why lenders (might) agree

It might seem counterintuitive for a lender to go along with a short sale. After all, a lender is legally entitled to pursue the full balance of the loan. When a homeowner falls behind on payments, the lender can (and often does) hold the borrower responsible for every penny owed.

And yet more and more lenders are willing to consider approving short sales. In a January survey of senior loan officers conducted by the Federal Reserve Board, more than 65% of those surveyed said they anticipated short sales to be among significant loss-mitigation steps for 2008.

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Lenders are painfully aware of just how bad the foreclosure crisis is. They know the cold reality is that a large number of struggling borrowers will end up losing their homes and often see the sense in accepting the inevitable and trying to minimize their losses. Yet some lenders seem to remain in denial.

"Some of them are being tougher right now than they have a right to be," says Richard Geller of MortgageReliefFormula.com. "I wonder if they expect a big bailout somehow. I expect lenders to get a lot more desperate later in 2008."

Foreclosure is an expensive and time-consuming process for a lender. By agreeing to a short sale, the lender wraps up its little mess quickly and perhaps with a smaller loss than in a foreclosure.

Remember that after foreclosing the lender owns the home and has to maintain it, insure it and pay taxes on it. So instead of receiving payments each month, the lender is now forking out money every month. Plus, short sales help the lender look good on paper -- the property never gets listed as an actual foreclosure, which helps the lender's numbers. Lenders often see short sales as the lesser of two evils -- if the numbers make sense for them.

Continued: Identify potential short sales

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