(For more about short sales, see “What is a Short Sale? The Short Sale Process In Washington Explained”. For more about REOs, see “REO or Bank owned Homes Explained: Buying REO Property“.)

WHAT IS A HARDSHIP LETTER?

First, some background: When a lender considers a short sale, it must take into account both the big and the little pictures. As to the little picture — the specific proposed sale — the bank will probably benefit from any short sale that is even close to fair market value of the property. Otherwise the bank will have to foreclose on the property, only to probably take it back at the foreclosure auction. The bank will then have to sell the property itself. All the while, until the property is actually sold and the bank recovers the principal (or a portion of it) the bank is incurring a loss based on the “time-value” of money. Plus, the bank incurs substantial costs in the foreclosure process and again in selling the property to an eventual buyer. These costs are avoided if the bank approves the short sale.

BANKS ENCOURAGE FULL REPAYMENT

On the other hand, the bank also has a big picture concern as well. Quite simply, the bank wants to strongly encourage borrowers to remain good for the debt if they can afford it. Otherwise, the bank — all banks, really — will be even more overwhelmed with defaulting borrowers.

Accordingly, a bank will typically approve a short sale only if the owner has some sort of hardship that makes it difficult or impossible to make the mortgage payments. That is why banks require a hardship letter when requested to approve a short sale.

Thus, a hardship letter is a written statement from the owner about why the owner cannot afford the mortgage. While short sale standards vary from lender to lender, and while they also evolve over time, the hardship letter is generally an important part of the short sale application. Any owner looking for an approved short sale should take the time to draft a compelling hardship letter.

HOW TO WRITE A HARDSHIP LETTER

In drafting the letter, think creatively. Identify any possible hardship that has had a negative impact on your ability to pay the mortgage. Have you lost your job, or are you about to? Has somebody in your family incurred substantial medical bills? Is there any other unusual or unanticipated expense that impairs your ability to make the mortgage payment? Play up those hardships.

That said, there are of course limits. It is a very serious federal crime to make a false statement to a bank. Accordingly, while you can “play up” a hardship, you cannot lie or misrepresent the truth. Its a fine line, and its important to remain on the right side of it.

If you take the time to write a well thought out and compelling hardship letter, you will be taking a big step towards a successful short sale.

As always, this post is NOT legal advice. For legal advice, you must consult an attorney about your specific situation.

Are you planning to buy or sell your home this spring? The real estate market has changed considerably. There are significant opportunities, and there are risks. Know your options! We have answers to questions like: What’s an “REO”? What’s a “short sale”? How do foreclosures affect market values?

We’ve scheduled a series of home buyer seminars around the Seattle and Bellevue area. We are co-hosting these events with Cobalt Mortgage. We’ll have complimentary refreshments, and we’ll discuss market conditions, mortgages, and paying real estate agent commissions versus paying a flat fee.

Is This a Seminar for First Time Home Buyers? Who Should Attend?

The seminar is for anyone interested in learning more about buying or selling a home in today’s market including first time home buyers, repeat buyers, and sellers.

Next Class:  July 20^th Downtown at the WaLaw Realty Offices

2033 Sixth Ave., Ste. 990, Seattle, WA 98121
Click here to RSVP and get directions to the Downtown Seattle Home Buyer Seminar.

RSVP Appreciated But Not Required:

If you’re planning on attending, let us know by reserving your space using the link above. Or you can tell Robyn at 206-357-4209 or by email at robyn@walawrealty.com.  If you decide to attend at the last minute, no problem!

Short Sale vs. Foreclosure: What’s the difference and is one better than the other? Many, many people now own property that is worth less than the amount owed on it.  Moreover, many people purchased the proverbial “starter home” within the last five years, and they’re ready to move on to their next home (commonly kids are on the way).  Under these circumstances, an owner can either sell the home and then write a check at closing for the balance owed — OUCH! — or get rid of the home with, hopefully, cancellation of the balance of the debt.

If you’re hoping to avoid the debt without repaying it in full — like most people — then you have essentially two options: You can either seek a “short sale,” or you can let the home go to foreclosure.  There are advantages and disadvantages to each. (For more about short sales, see “What is a Short Sale? The Short Sale Process In Washington Explained”.)

SHORT SALES AND FORECLOSURES SHARE A SIGNIFICANT DOWNSIDE

First, though, there is one disadvantage common to both: Your credit will be ruined.  Your credit score tells potential creditors whether you are a “good debtor,” i.e. whether you repay your debts on time and in full.  Unless you write that check at closing, you will not have repaid this very substantial debt on time or in full.  Your credit score will reflect that outcome.  Generally speaking, it takes credit scores seven years to fully recover from this sort of negative report.

ADVANTAGES OF A SHORT SALE OVER A FORECLOSURE

So what are the advantages of a short sale? First, a short sale will probably have less of a negative impact on your credit score over the long term.  Moreover, Fannie Mae guidelines now prohibit it from buying any mortgage issued to a debtor who had a short sale in the last two years, compared to seven years for a foreclosure.  Accordingly, if you think you’ll want to buy again anywhere from two to seven years down the road, a short sale is better.

DISADVANTAGES OF A SHORT SALE

What about the disadvantages?  There are several.

1. It is hard to sell your home.  It requires a lot of patience and effort, and with a short sale you won’t see a nickel of the proceeds, which all go to the lender.  At the same time, banks are notoriously difficult to deal with in seeking short sale approval.  Plus, most short sales fail, so you will likely invest that effort without getting a good result.
2. To sell the home you only need the lender to release its lien on the property.  In some instances, the lender will do so but will not release you from the debt obligation.  In that instance, you may need to keep paying for a house you no longer own — double OUCH!
3. There’s even a downside if the lender does release you from the debt.  While you won’t have to repay the debt in full, you might be liable for income tax on the forgiven amount.  You will likely avoid that tax bill (the amount of the forgiven debt times your top tax rate) only if you are living in the home at the time of the sale. This is a temporary exclusion from income (until 2013) established by the Mortgage Forgiveness Debt Relief Act of 2007.

ADVANTAGES OF A FORECLOSURE

A foreclosure, on the other hand, may avoid many of the disadvantages that come with a short sale.

1. A foreclosure requires virtually no work.  All you do is stop paying the mortgage, and you can continue to live in the home “rent free” until foreclosure.  You don’t need to even talk to the bank, let alone “negotiate” some voluntary resolution.
2. A foreclosure extinguishes the debt being foreclosed, so you don’t have to worry about continuing to owe money on a house you don’t own. Note that the debt of any second mortgages or other junior lien will survive foreclosure of the first mortgage, so be very careful if you have more than one mortgage.
3. Finally, you are less likely to have any tax liability in the event of a foreclosure.  The law on this issue is still being sorted out by attorneys and courts, so there is no universally accepted analysis of this issue.  That said, a foreclosure will probably not lead to any income tax liability even if the auction price is less than the amount owed.

DISADVANTAGES OF A FORECLOSURE

The downside of a foreclosure?  As noted above, it’s worse for your credit.  Moreover, many people think it is simply wrong to not repay your debts, and a short sale is at least a good faith effort to mitigate the problem for everyone.  Simply allowing the property to go to foreclosure just punts the problem entirely into the bank’s lap.  But I’m a lawyer, not an ethicist so I’ll leave it to you as to whether stiffing your creditor entirely is a disadvantage.

This post simply touches on some of the relevant considerations.  If you’re thinking of either a short sale or a foreclosure, you should consult an attorney or other tax professional about what is best in your specific situation.

I tend to agree with Professor White. It seems to me that people are held to an unfair standard of “morality” when it comes to business decisions, a standard that is not applied to a business entity. For example, if a corporation stands to benefit from breaching a contract, you can bet your bottom dollar that the corporation will avoid its contractual obligations. Nobody will bat an eye.

A person, however, is held to a different standard. When a person enters a contract — including a mortgage — it is assumed that the person has given his “word,” his solemn moral promise. Even where the person stands to lose money by performing his contractual obligations, many people think that the person simply must soldier on and must comply with the contract or he has acted “immorally.”  Don’t believe me?  Check out these comments.

From my perspective, people should do what is in their best self interests. If defaulting on a mortgage is the best course of action, all things considered (including damage to credit score), then the borrower should default. The lender took a risk when it loaned the money, a risk reduced but not eliminated by securing that loan with the house at issue. Thus, the lender — just as much as the buyer — took a risk that house values would decrease, thus jeopardizing the security for the loan. The lender, then, should be prepared for the consequences.

I think Professor’s point is a good one: people don’t default because of social pressures to not do so, social pressures that are applied only to borrowers and not lenders.  This exacerbates the burden on people, to the benefit of the lenders, as a result of the market implosion.