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Foreclosure vs. Short Sale: What's the Difference?

The process for purchasing a foreclosure and short sale differs. Find out the differences.

[Updated: Mar 02, 2021 ] Dec 24, 2020 by Laura Agadoni
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If you're interested in getting a good deal when buying investment property, you might wish to purchase a short sale property or foreclosure, both typically discount or distressed properties. Before you dive in, though, there are many factors to consider, including the differences between the two.

The differences

Investors can snag a great deal by buying a short sale or a foreclosure. But with a great deal often comes risk, or at least headaches getting through the short sale or foreclosure process. Let's explore the differences between the two to help you decide which, if either, is the right investment vehicle for you.

What is a foreclosure?

A foreclosure is an involuntary transaction on the part of the homeowner. When a homeowner stops paying their mortgage, generally for three months, a mortgage lender or lienholder can call in the loan and take back the property. This is called a foreclosure. Some lenders wait a bit longer, such as six months of nonpayment, before they foreclose.

Lenders must follow specific procedures according to their state law on how to proceed with the foreclosure, such as sending a notice to the borrower and only going through with the foreclosure if the borrower doesn't take action to reinstate the loan.

You can buy a foreclosed home at a sheriff's or foreclosure auction held on the city's courthouse steps. If the property doesn't sell there, it goes back to the bank, and you can buy it as a real estate owned, or REO, property.

What is a short sale?

A short sale is a voluntary transaction on the part of the homeowner. When a homeowner is underwater on their home, owing more than what the home is worth, they might want to get out of the deal and sell that house. The deal is called a short sale because they would be selling the home for less than what they owe the lender -- they would come "short" of what they owe.

Since lenders won't be receiving the amount of money they're owed, they must approve a short sale before it can happen. Some lenders can seek a deficiency judgment to get the money still owed to them after the short sale, but some lenders accept the shortfall and don't come after the borrower.

Short sales were common during the 2008 mortgage crisis since many people bought at the top of the bubble and then saw their house price plummet soon after. Although not as common today, homeowners can still find themselves in this position. As of the first quarter of 2019, for example, over 5.2 million properties, or 9.1% of all U.S. properties, were underwater compared with a whopping 30% of people who were underwater in 2008.

Why an investor would want to buy a foreclosure

During tough economic times, like the one we're experiencing in 2020, more homes fall into foreclosure status. Because of lockdowns associated with the coronavirus, many people lost their jobs and some might not be able to make their mortgage payments -- even with government help like the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act, or a suspension of foreclosures for a certain period. Here are a couple of reasons for choosing a foreclosure property.

Low price point

More distressed homeowners means there will probably be more foreclosures on the market in 2021, so many real estate investors will want to act. Foreclosed homes are already discounted, and when more hit the market, prices should drop even further.

Good potential ROI

Another reason investors like to buy foreclosures is their potential for a good return on investment, or ROI. Because of their low price, investors can generally fix them up and resell them for a profit -- as in a flip -- or they can hold onto them and rent them out.

Why an investor would want to buy a short sale

Investors who want to get a discounted home but are not prepared to deal with all the repair work many foreclosed homes need -- often a complete renovation -- might choose a short sale property.

Better condition

Short sales are generally in better condition than foreclosures since the property owner is usually still living in the home until the home sells. With foreclosures, the former owner might have vacated the property, and the property might sit vacant for months or even years, all the while deteriorating if no one is keeping up with it. Plus, some people become so upset when faced with a foreclosure that they purposely damage the home. But a short sale is voluntary, so the homeowner has no reason to destroy it.

Slower time frame

Another issue to consider with a short sale is the time frame. The short sale process is slow, much slower than buying a foreclosure. The bank needs to review the reason the seller is requesting the short sale, so the application and review process is much the same as the mortgage approval process; the bank looks at the seller's overall finances and then decides.

It could take four months or more, even a year, for a short sale deal to go through. Note that if you have an interest rate lock, it could expire. But if you as an investor don't have all your financing arranged and need some time, you might welcome the delay, making the lengthy time frame a benefit for you.

How to decide which might be better for you

If you want to invest in a short sale or foreclosure property but aren't sure which one, here are some takeaways:

  • A short-sale transaction is more like a standard sale. The only difference is that after the seller accepts your offer, the bank needs to approve it. Then it becomes a waiting game, and the deal might not happen. But you can get a mortgage loan to buy a short sale, and you can get the property inspected.
  • A foreclosure sale is not like a standard sale. You often can't get a mortgage loan to buy one; you need cash. In some cases, depending on the condition of the house, you might be able to get a mortgage loan on an REO property, but if you buy at auction, you typically need cash.
  • A short-sale home is usually in better condition than a foreclosure. If you're not in the renovation game, you might want to steer away from a foreclosure or get a team of contractors in place before you buy. Otherwise, you might pay too much to repair the property, making what you thought was a great deal not so good.
  • Buying foreclosures at auction usually means you're competing with seasoned investors for the best deals. Unless you're prepared, you could be frustrated with the process.

The Millionacres bottom line

If you want to get in the real estate investing game by buying a short sale or foreclosure, decide your investing style and choose the one that works better for you. You might want to use a real estate agent who works with investors, at least for your first couple of times. An agent can offer advice to help ensure your best interests are met.

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