Do Banks Make More on Foreclosures or Short Sales?

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Question: Do Banks Make More Money on Foreclosures Than Short Sales?

A reader asks, "I've been trying to buy my first home but in the price range I'm looking all the homes are short sales. My agent is trying to talk me out of buying a short sale because she says banks would rather foreclose than do a short sale. Is that true? Do banks make more money on foreclosures than short sales?"

Answer:  The question of whether a bank makes more money on a foreclosure than a short sale depends mostly on the individual bank and/or the investors.

Because, by very definition, a short sale is granting the homeowner permission to sell their property for less than the home owner owes the bank. As a result, the bank automatically loses money on it.

“If the bank ends up getting the same or less than they would have with a short sale, they will suffer a big loss,” said Mark Bello, an attorney in West Bloomfield, Michigan. “Assuming foreclosure is eminent, the bank will only reject a short sale if their own market sale will recover more of their money.”

The 2005 real estate market saw foreclosure notices filed in unprecedented proportions. Moreover, at least half of the loan modifications were defaulted upon shortly after they were granted. But since then, the market has rebounded. Data by year shows that 45 percent of all properties in foreclosure as of the end of the first quarter in 2018 were due to loans secured from 2004 to 2008, according to ATTOM Data Solutions. Overall, a total of 189,870 U.S. properties were in foreclosure during the same timeframe, which was 32 percent below the first quarter of 2006 to third quarter 2007.

“There aren't as many serious examples of situations where people are extremely underwater on their mortgages so there's less and less need for short sales,” Bello told The Balance.

Depending on the state, a bank may not be able to sell a property for more than its mortgage. For example, in Arizona, banks can't sell a property for more than its mortgage and in California, if a homeowner takes out a home equity loan after closing escrow and then defaults, the lender may have a right to pursue a deficiency judgment regardless of whether the home was sold on a short sale or the loan was wiped out through a foreclosure by the first lender.

Why Would Banks Prefer a Short Sale over a Foreclosure?

Banks are run like a business because they are a business looking to earn a profit. If it costs more to foreclose over agreeing to a short sale, the bank is very likely to favor the short sale.

With foreclosure, a bank takes possession of the house then resells it at a mortgage auction to the highest bidder. If a bank receives an offer that is close to market value, it may be more likely to accept that offer instead of foreclosing. Why? Because after foreclosure, if the bank wants to sell the home, it is unlikely to receive a higher offer than the short sale offer on the table. On the other hand, if the bank feels the real estate market may appreciate, a foreclosure may be a more profitable venture.

Service Providers May Decide Whether to Grant a Short Sale or Recommend a Foreclosure

About two-thirds of the loans made since 2005 have been securitized, according to the National Consumer Law Center. Securitization is a process that involves gathering hundreds to thousands of loans into one package and selling that package in the secondary market.

“Companies that acquire bad debt do so at a substantial discount,” said Bello. “They look to collect more from this bad risk then they paid for that debt because bad debt can be purchased for pennies on a dollar.”

Often, the purchaser is a trust, which are comprised of investors. After the loans are pooled and sold, the trust hires a service provider to collect monthly payments and distribute that money to the investors. That securitization agreement is called a pooling and servicer agreement or PSA.

It matters little to service providers whether the home's value falls or enters foreclosure because the service provider gets paid regardless through service fees, default fees, floated interest and/or from investment interest on the loans the provider services.

Further, the National Consumer Law Center found that service providers often prefer a short sale because they are paid several times more in compensation than a loan modification.

“The difference between a loan modification and a short sale is you’re not rid of the property,” said Bello. “You’ve just kicked the can down the road.”

Tip: For the most part, banks are unlikely to reject a short sale if the sales price is near market value.

At the time of writing, Elizabeth Weintraub, License #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.

Updated by Juliette Fairley June 3, 2019