Buying After a Short Sale is an Excellent Mortgage Credit Risk

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While lenders will admit that it’s technically possible to provide mortgages to homebuyers who recently had a short sale without a waiting period, most lenders are not offering this product (for the record, we are offering it).  Because of the complexities of the process involved with closing these loans that creates perceived risk, most lenders elect not to do them and fail to ask the more important question. . .  “Are they a good credit risk?”  The principles of underwriting mortgages and loans in general are outlined in the Four C’s (Credit, Collateral, Character and Capacity).  By these measurements, borrowers who comply with the provisions of FHA’s Mortgagee Letter 09-52 are very good risks for a lender.

CAPACITY

Homebuyers are not eligible for a new FHA mortgage if they pursued a short sale agreement on his or her principal residence simply to take advantage of declining market conditions, and purchase, at a reduced price, a similar or superior property within a reasonable commuting distance.  To comply with this provision, one must take a step down in housing, relocate or buy a wholly dissimilar property (i.e. going from a single family residence to a townhome).  In non-relocation situations, which is by far the majority of them, people are taking a dramatic step down in housing expense; thus improving their debt to income ratio.  Because borrowers are only considered eligible for a new FHA-insured mortgage if they were current on their mortgage and other installment debts at the time of the short sale of their previously owned property and their new payment will likely be much less, it’s only reasonable to assume that their capacity to repay the loan is enhanced from what is previously was when their loan was already current.

CREDIT

Different lenders report short sales to the credit bureau in different ways.  I’ve seen them report as charge offs, paid collections and mortgages with the comment, “creditor settled for less than the amount due.”  The last of these is the most common and the most damaging.  While nobody but Fair Isaac can claim to know the algorithms for credit scoring, I’ve seen score drops ranging from 43 points to 89 points and it seems to depend largely on the depth of the borrower’s credit report (if it were truly treated like a foreclosure, Fair Issac claims it can be as many as 150 points).  Needless to say, for someone to have a qualifying FHA credit score for a mortgage after a credit hit like this, it is a compliment to the borrower’s payment performance and credit management.  The fact that this credit score is maintained through a financial hardship that was recognized and affirmed by their previous mortgage lender only further fortifies this compliment.

CHARACTER

As mentioned, a completed short sale involves a financial hardship on the part of the seller that was recognized and affirmed by their lender but they also take a long time.  In my market, it currently takes 215 days on the market before a sale.  This means that not only is this homeowner likely under stress for a period of months prior to listing the property but, under hardship they need to wait another 7 plus months before they’re in the clear.  All the while, they manage to remain current on their mortgage and installment debts (we assume this because we’re talking specifically about people who would be eligible to buy a home right away after a short sale).

The other component of this is what I call the Equator SNAFU.  This isn’t the case with all loan servicers but often times when a short sale package is registered in the Equator system, a loan servicer puts a code on the loan.  This code can trigger a series of events but one of them can be that the lender stops accepting payments in the usual ways.  I often hear horror stories where homeowners in a short sale have to call every month and spend 20 minutes on the phone forcing the lender to take their payment.

In any event, when a homeowner goes through this prolonged period of financial hardship and still manages to pay their mortgage and other installment debts on time and see that they get posted on time speaks volume of their character as it shows how much they care about the quality of their credit rating and shows good faith to the lender under circumstances where many others, and some would say most, do not.

COLLATERAL

Because in most cases (barring relocation) one must take a step down in housing or buy a wholly dissimilar property in order to qualify for a FHA insured mortgage without a waiting period after a short sale, an additional step must be taken with the appraisal of the new property.  In addition to the analysis that goes into every FHA transaction, the details of the new property must be carefully compared to the home previously sold short.  This by itself does not ensure that collateral/home secured by the new loan is more secure per se.  What it does do is force those involved in approving the loan to more carefully scrutinize the details of the appraisal.  Only good things can come from spending more time analyzing an appraisal (why do I hear some of you Realtors and Loan Officers reading this snickeringJ).

CONCLUSION

While the four C’s of underwriting are applied to nearly every loan, there are situations that are unique to the buyer who is eligible for purchasing after a short sale without a waiting period using FHA insured financing that present a picture of that borrower in a light we don’t normally see.  I would argue that for the reasons outlined above, it should be assumed that they should be looked at through a preferential light since it is inherent that, according to the principles we make loan decisions by, the borrower has already more than simply passed the test.  The only justifiable questions to consider are whether the agreement between the borrower and their previous lender served as satisfaction in full and whether or not the new property meets the “step down or dissimilar test.”  But, neither one of those questions speak to the borrower’s Credit, Capacity or Character.  Those are inherently not in question.

THE MORAL COMPONENT FOR LENDERS

Aggressively taking steps to make these loans available is important for homebuyers and lenders alike.  It gives lenders the change to justifiably write down loans that their bank examiners hate (without foreclosing), the lenders get a chance to write new quality loans and gives homeowners the chance to deleverage without leaving homeownership.  All of these things are good for the housing market and the economy as a whole.

The housing market won’t make a meaningful recovery until the job market does.  The job market won’t recover until consumer spending picks up.  Consumer spending won’t meaningfully pick up until the negative equity problem is tackled.

A similar crisis happened after the revolutionary war when our country was in debt up to its eyeballs and couldn’t figure out why the economy wouldn’t jump start.  The difference in this case was the solution. They noticed that all of their entrepreneurs were holding onto bars and staring through the window of debtor prisons so there was no dynamism in the marketplace.  In 1800 . . . enter the bankruptcy code.  This was a contributing factor to a major economic expansion of the time.  Short sales are the modern day version of the introduction of the bankruptcy code.  Only this time, barring a nationwide ban on 1st lien deficiency judgments, the government can’t help.

Just think about it, . . . What percentage of homeowners in your area are upside down on their home, suffering a hardship and current on their mortgage and installment debt?  The numbers are staggering.  How many of them would contemplate a short sale if they knew they could remain in homeownership?  Many are postponing the inevitable simply for the hope of holding onto the dream of homeownership that 9 out of 10 still hold dear.

Educated homeowners are on board . . . Realtors are on board . . . it’s time that lenders got in the game.

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Charles Dailey – Branch Manager, Loan Officer, Certified Military Housing Specialist – CA DOC, MN DOC & WI DFI

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