In a short sale, your mortgage lender agrees to let you sell your house for an amount that is less than you owe, and forgives any extra debt remaining after the house sells. This essentially means that they’re giving you money for free, at least on paper.

Note: this only works if your house is currently worth less than you owe on your mortgage. 

You must be underwater on your mortgage in order to qualify for a short sale, which means that you have negative equity.

This can happen for a variety of reasons:

A real estate market downturn lowered your home’s value below the amount you borrowed to purchase it

The debt from a second mortgage or a home equity line of credit (HELOC), combined with your primary loan, now totals more than the house is worth

Missed mortgage payments, delinquency fees, interest charges that added up

Negative equity isn’t the only criteria you need to meet in order to qualify for a short sale, though. In order for a mortgage company to consider a short sale, the property needs to be in imminent risk of foreclosure. Lenders will not consider a short sale if there is no foreclosure pending.

“The borrowers must also be able to demonstrate a distressed financial situation. The mortgage company will look for hardship factors like, divorce, the loss of a job—which is a loss of income—or devaluation of the home, meaning that the house is currently worth less than the borrowers paid for it, putting them underwater on the property.”

Bottom line: If you’re underwater on your mortgage, if you’ve received pending foreclosure notices, and you can demonstrate financial distress, you may qualify for a short sale—as long as your lender agrees.

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Short sales and foreclosures are often lumped together because both are rock bottom options for homeowners who are behind on their mortgage payments and in financial hot water.

They aren’t the same, though.

When you’ve reached foreclosure stage, the bank has taken the house from you because you’ve defaulted on your mortgage. In that scenario, your lender cuts their losses and will move to evict you. When your house eventually sells, the bank is the one selling it—you are no longer involved.

However, letting your lender foreclose on your house doesn’t necessarily mean you’re freed from your mortgage debt. Depending on where you live, your lender can sue you to recoup some of what you owe.

None of this happens with a short sale. When you arrange for a short sale, your lender is agreeing to forgive any extra debt after the house is sold for less than you owe.

Lenders aren’t in the business of giving away free money to just anyone. You’ll need proof that you’re in dire financial straits and unable to pay what you owe on your home. You’re going to have to show your lender all of your personal finance documentation. That’s going to include your most recent bank statements, your pay stubs, your credit card debt, and also your monthly expenses.

Aside from financial statements, your lender will also require several other documents when you apply for a short sale arrangement, including:

• Third-party authorization letter (gives your agent permission to work with your lender on the short sale)

• Client information form (your application)

• Tax returns from the past two years

• All bank statements from the last two months

• Most recent mortgage statement(s) (all mortgages loans on the property)

• Financial statement (including all assets and debts, such as retirement account statements, credit card debt, etc.)

• Hardship letter

The only way to qualify for a short sale is if you currently owe more than your house is worth. So, how is the current value determined? That depends.

There are basically two options to get to your home’s current value, either with a broker price opinion (BPO), or an appraisal by a licensed appraiser.

“With a BPO, the agent prepares the valuation—versus a licensed appraiser, whose perception of the market can be different. Which one will be required in your short sale depends on the lender advises .

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Yes. Going through with a short sale will have a negative impact on your credit.

However, your credit score can recover more quickly after a short sale than it can after a foreclosure. And once your credit score has recovered, you’ll qualify for a guaranteed mortgage more quickly after a short sale versus a foreclosure.

This is only true if you return to your good credit habits after the short sale, by keeping your credit debt low and making payments on time. If you do, then your credit could potentially start to recover after two years post-short sale.

Since a short sale reflects the borrower’s willingness to settle debt, many lenders will take this under consideration when you apply for future loans.

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If yours is a recourse loan, the bank can go after your other assets to collect on the deficiency amount left after the home sale. Lenders who instead decide to forgive the remaining debt on a recourse loan will send you a 1099 because it’s considered income.

If yours is a non-recourse loan, the bank cannot go after your other assets to collect on any remaining debt. Any debt amount left after the house is sold to pay off a non-recourse loan is not considered cancellation of debt income. So you will not receive a 1099.

It’s in your best interest to hire an agent well-versed in short sales because they are different than a traditional listing.

Lenders require a lot of financial reporting that needs to be gathered and coordinated. Your agent will also help coach the buyer on how the short sale process works and keep their expectations realistic.

Mortgage companies want you to use an agent to help you through a short sale.

Lenders are happy to pay the real estate fees because they know the short sale will be more successful if an experienced agent handles it. But, if you hire an agent who hasn’t gone through the process before, then you’re rolling the dice and hoping that it’s going to be successful.