What Is an Arm's Length Transaction?

Arm's Length Transactions Explained in Less Than 4 Minutes

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An arm's-length transaction is one in which there is a written promise to a lender that the parties involved in a sales transaction don't know each other.

Learn why lenders require arm's length transactions during short sales and how they work.

Definition and Examples of Arm's Length Transaction

In an arm's length transaction, there is no pre-existing relationship between the seller and the buyer. This helps ensure the property is priced fairly, because each party (as well as the lender) should have access to relevant information regarding the home.

Arm's length transactions are commonly required for short sales, which are an alternative to foreclosure. In a short sale, a lender allows a homeowner to sell their home to pay off their mortgage, even if the sale doesn't net enough to pay off the balance of the homeowner's mortgage. The process varies by state, and in some states, the lender may be able to collect the difference between the sales price and the mortgage balance.

Before moving forward with a short sale, homeowners should ask their lender for a waiver of deficiency, so they aren't on the hook for paying the difference between the sale price and the remaining mortgage balance. They may also want to review their options with an attorney or a HUD-approved housing counselor.

Lenders will often require an arm's length affidavit during a short sale in an attempt to prevent sellers from selling to a relative. The affidavit requires each party to confirm that there are no secret dealings, hidden terms, or undisclosed understandings.

For instance, say you are struggling with paying your mortgage, and you owe $250,000 on your home loan. Your lender may approve a short sale for a price of $175,000. This helps you get out from under the burden of your home loan, while also allowing the lender to recoup some of the cost. However, the lender requires that you send an arm's length affidavit, showing that you aren't hiding any secret relationship with the intended buyer or keeping such relevant information from the lender.

In other words, the lender has approved you selling the home for less than you owe, but they want to make sure you aren't trying to defraud them by colluding with the buyer.

How an Arm's Length Transaction Works

In an arm's length transaction, both buyer and seller are working independently to secure the best outcome for themselves. If that transaction is a real estate deal involving a lender, they may be required to sign an arm's length affidavit that expressly states that the buyer and seller aren't working for their mutual benefit. It may also require that the seller leave the property after the sale, having given up their claim.

The lender might also require an appraisal or analysis of the property to be sure of fair market pricing.

If the buyer and seller are related to each other, or share a business interest, that's not an arm's length transaction.

Preventing Fraud

An arm's length transaction helps everyone involved in the transaction be reassured that the price and conditions of the sale are fair and true. Many banks have cracked down on fraud and short sale scams by requiring an arm's length sale.

Lying to the bank or misrepresenting a detail in order to influence the bank's decision constitutes mortgage fraud. It's a crime the FBI may aggressively pursue, as it is considered a form of financial institution fraud.

In one example of a mortgage fraud involving a short sale, a seller makes a side agreement with a relative or friend, who then agrees to act as a straw buyer. Once the transaction closes, that pretend buyer quickly transfers the title back to the seller. This effectively enables the seller to repurchase their home at a steep discount, allowing them to remain in the same home, but with a significantly smaller mortgage.

To avoid such mortgage fraud, banks have determined that sellers in a short sale can't benefit other than being able to move out of their home with a short sale, and not a foreclosure, on their credit report. To ensure this, they will require an arm's length affidavit to attest that there is no pre-existing relationship between buyer and seller.

An arm's length transaction is usually best for everyone involved. If you're on either side of a short sale, don't try to beat the system. Instead, work with a reputable real estate agent with experience in short sales, and disclose your relationship with the other party if one exists.

If you're experiencing difficulties in paying your mortgage, talk to your lender. Be cautious about potential scams and read any documents carefully before signing.

Key Takeaways

  • An arm's length transaction is one where the buyer and seller don't have a pre-existing relationship.
  • Mortgage lenders in short sales often want both parties to confirm that the sale is an arm's length transaction.
  • Arm's length transactions are designed to ensure that all parties have access to relevant information about the sale, and that there are no hidden dealings or understandings.