Aloha,
It sure is not fun to talk about, but in the current market we are seeing quite a few "Short Sales". What is a Short Sale? A short sale is when a bank or mortgage lender agrees to discount a loan balance due to an economic hardship on the part of the mortgagor. It is the unenviable situation where someone has to sell their property for less than they currently owe. The need to do this is usually a result of a declining market, and a change in financial situation (unemployment, increase in adjustable rate mortgage). This is done to avoid foreclosure. The bank or lender will choose a short sale if they believe it will result in a smaller financial loss than foreclosure.
In short, a short sale is nothing more than negotiating with lien holders a payoff for less than what they are owed, or rather a sale of a debt, generally on a piece of real estate, short of the full debt amount.
The biggest headache facing short sales today is the action of the junior lien holders. This may be from a 10% loan at purchase to avoid paying Mortgage Insurance or a Home Equity Loan when the market was stronger. The second lien holders have the right to approve or disapprove. In the past they would approve for a modest $1,000-$2,000. They do this knowing something is better than nothing, and if the house forecloses they get nothing. However, we are seeing a significantly large number of these second lien holders demanding much larger payoffs for their approval, on the order of $10,000 to $30,000. These junior lien holders are in effect holding the short sale hostage.
Junior lien holders have become keenly aware that short sellers often do have access to cash through family or investments, and wanting to avoid foreclosure, sellers will come up with the money. A recent example was from a very large national lender who, even though they had completely written off a loan and zeroed it out in their books as a loss, demanded payoff and only signed off at the 11th hour when the sellers came up with $10,000 in cash. It is important to note that these junior lien holders are still seeing significant losses even with large payoffs.
What does all of this do to a homeowner's credit? Simply put, avoiding foreclosure is a good thing. While a short sale will not look good on your credit, you will have to ability to pick up the pieces a few years down the road and re-establish your credit. In fact, as a number of mortgage brokers have told me, bankruptcy is better for ones credit when buying a home than foreclosure. Keep in mind that the junior lien holder will often refuse to zero out the balance owed, even when they agree to a payoff. If you do have to complete a short sale, and the junior lien holders have agreed to a payoff, get assurances in writing as a condition of the payoff their agreement to not put the outstanding balance on your credit. This will also go a long way in restoring your credit.