When you give a mortgage on your property, you are granting the lender a lien on the property that can be discharged or satisfied in only three ways. One way is to pay the lender the full amount it is due on the Note the mortgage secures. In a sale situation, a payoff letter is ordered by the title company handling the closing and from the proceeds paid by the Purchaser, the amount due the lender is set aside and paid to it in exchange for the lender’s discharge of the mortgage. Other than paying the lender off in full, the only other way to obtain a discharge of the mortgage is to obtain the lender’s consent to discharge its mortgage without payment or with a payment less than the amount owed by the lender. The third way to obtain a discharge is to “lien strip” the lender’s mortgage in a Chapter 13 Bankruptcy case. Lien Stripping is a great tool we use in Chapter 13 Bankrupties, but it only applies to junior mortgages where there is no equity attaching to the junior mortgage.
A Short Sale is the situation where a lender consents to discharge its mortgage without regard to the payment amount it receives. This means the property (typically a residential home) is sold for less than the outstanding balance owed on the mortgages of the property. A Short Sale can only occur with the consent of the mortgage company that is not receiving full payment of the balance it is owed. The lender’s consent allows the property to be sold and the lender releases its mortgage lien against the property.
There are a couple of issues in play here. First, the terms of the lender’s consent are controlled by the lender. The lender will issue a letter indicating the terms by which it will agree to release its lien for less than the amount owed. This letter typically spells out conditions that must be satisfied, including the amount of proceeds to be paid by the lender, warranties and representation from the owner of the property designed to prohibit any form of collusion between the Seller and Purchaser from the lender’s perspective. In order to gain the benefit of the short sale, there must be compliance with the specified terms.
A critical component in any Short Sale is whether the lender is agreeing to release its remaining claim against the mortgage holder. This is often assumed to be the case – but it is not something you can assume. In any situation where a Short Sale is in play, the mortgage holder who is seeking to have the mortgage and debt discharged must be sure it is clearly spelled out in writing that the discharge of the mortgage is also a release of any claim by the lender on the debt. You cannot believe the real estate salesperson, the title company processor or the representative of the lender. You must verity this fact in writing! I repeat, you must verify this fact in writing!
Now let’s focus on the process. The process is different when the person agreeing to the short sales is the holder of a first mortgage compared to a junior mortgage holder. In many markets, a lender holding the first mortgage will not consider granting its consent to a short sale unless the property has been actively marketed for two to three months. The reasoning is that the lender is seeking to assure itself that the price being paid for the home is the market price. The lender is trying to make sure the property is not being sold for less than what it could or should be sold. If you think about it, this makes sense. The lender is not agreeing to take less than it is owed because they are “nice,” “committed to the community” or any other social cause. They are doing so, only because they recognize that it is economically in their interest to have the mortgage holder market and find a buyer for the property at the best price attainable rather than to go through the time, cost and risk to the property that arises when the property is foreclosed. In this connection, in addition to the requirement that the property is on the market, most lenders will not give consideration to accepting a short sale unless the homeowner is behind on the payments – which acts to demonstrate to the lender that there is a substantial risk of foreclosure if the short sale is not accepted.
Junior mortgages are a bit different. The interest of the junior mortgage holder is dependent upon the market value of the home compared to the first mortgage. If the market value of the home is less than the first mortgage, the junior mortgage holder is in a position where it will realize no money upon the foreclosure of the home by the first lender or by the junior lender. The reason is that the proceeds of the sale, after selling costs, will ultimately go toward satisfying a portion of the first mortgage holder’s lien. The junior mortgage holder, in this instance, can play the role of the obstructionist, Remember – the mortgage holder, whether first or junior does not have to consent to release its lien unless it is paid in full. In the short sale, the first mortgage holder agrees to release it lien for less than it is owed (we called this “going short” or a “short pay”) because it is getting what it believes to be the realistic proceeds from the sale of the property at market value – and it in fact do worse, not better, if it is forced to foreclose. The junior mortgage holder, however, is not going to get anything out of the sale because the proposed purchase will not cover the first mortgage. So, will the junior mortgage holder release its lien for nothing since it is not in a position to gain from a foreclosure? The answer is that it could, but it typically will not. Instead, the junior mortgage holder will typically obstruct the sale by refusing to release its lien unless it is paid something – often times an amount in the range of $2,000 to $5,000. Here, the junior mortgage holder is interfering with the desired outcome of three parties – the Seller, the Purchaser and the First Mortgage Holder, as well as the real estate brokers who have worked to put the deal together. The junior mortgage holder uses its role and power as an obstructionist to effectively demand money (i.e. extort) for the release of its lien. Keep in mind; it is within the power of the junior mortgage holder to kill the entire deal. The normal outcome in this situation is that after numerous calls and emails between the brokers, the first mortgage holders, the Seller and the Purchaser, enough funds are contributed (by some or all of the parties) to satisfy the demand of the junior mortgage holder so that its discharge of the mortgage is obtained.
Will the junior mortgage also agree to release the owner (the Seller) from the remaining obligation on the note secured by the second mortgage? Here the answer is almost always, “no.” The reason is that the bargain struck with the junior mortgage holder is a payment of a nominal sum in exchange for its release of its lien – not for the discharge of the remaining debt. The junior mortgage holder retains its right to pursue collection of the remaining balance on its note from the owner. If you are in this situation, you need to know that you will have to address the possible claim of the junior mortgage holder at a later stage – in a manner similar with other debts you have such as credit card debt, student loans, etc. Keep in mind, this is expected in the context of the overall strategies that exist for shedding debt. You can only accomplish so much in certain transactions and at certain times. In the short sale setting, if you shed the first mortgage obligation and the first mortgage lender has released you from any remaining debt then you have accomplished a lot toward the master plan. As to the junior mortgage holder that used its postion to get some money, but has not discharged your debt, we’ll use other tools to address that issue.