Sell Yourself Short

The following is a guest post by Greg McFarlane.

What’s a short sale?

You buy a house. Years later, you can’t make the payments, so what do you do?

You can just stop paying, and the lender will eventually file an eviction order with the local constable. Depending on where you live, you can either laugh at the order or heed it. For the satisfaction of sticking it to the man for a few weeks, you’re out the price of your house and your credit rating, which will never recover. Which means you’ll never be able to get a credit card, not even from Capital One. What’s in your wallet? Nothing.

The less opprobrious and more financially savvy way to dishonor your contract is to sell your house short. Which involves going to the lender and pleading for mercy.

There’s something important to remember here, both to keep things truthful and to avoid embracing the mentality of a victim. When you ask the lender to accept a short sale, you’re not coming from a position of supplication just because you’re just an average Joe trying to get by while the heartless lender sits back in his corner office, laughing at your misfortune so hard that his monocle falls out and lands on his spats. You’d signed a contract that required you to cut monthly checks. There was no clause in the contract that read “if borrower loses his job, loads up on Fannie Mae common stock, gets divorced, has triplets, starts buying cigarettes by the carton, falls in love with a stripper or buys a boat, contract is void and subject to renegotiation at a lower rate.”

A little quantification might make this easier. Let’s use simple numbers. Five years ago, you bought a house for $150,000. You got a 30-year mortgage at 6%, which was average at the time. Fixed-rate*, of course. You put 20% down so you could avoid having to pay private mortgage insurance, the premium that lenders charge to borrowers whom they figure have lots of incentive to stop making payments if money gets tight. Which means this is your monthly payment:

.06 is your interest rate. 12 is the number of payments in a year. 360 is the number of payments over the life of the loan. 1 is the loneliest number that you’ll ever do.

Oh, stop whining. Yes, it’s math. The very calculator that comes with the computer you’re reading this on can solve it easily. Divide your interest rate by the number of months in a year, add 1, take to the -360th power, subtract from 1, multiply by the number of months in a year, divide into your interest rate, multiply by the amount you borrowed. DONE!

This makes a monthly payment of $719.46. Which doesn’t seem onerous for some people, but if you can’t pay it, you can’t pay it.

When you signed that mortgage, you committed to pay $259,005.83 in equal monthly installments over the next 30 years. Say you’re five years in and you can’t make the payments. You’ve already paid $43,167.60, assuming you haven’t missed any payments, which you probably have. That leaves $215,838.23. Selling short means that if you can’t make your payments, you tell your lender you’re willing to sell your house at a loss.

For a short sale to make sense, your house had to have depreciated. If that’s not obvious, consider that if you couldn’t make the payments, you could just sell the house for at least what you paid for it and not come out behind. Say property values in your area have fallen 30% since you bought the house. Your house is now worth $105,000. With the lender looking over your shoulder, you sell it for that much. What happens?

Well, the good news is you’re not on the hook for $215,838.23, or anything near it: the new buyer will now have a 30-year obligation. But because the house got cheaper, and interest rates happened to follow suit, the new buyer’s obligation will be a lot less than yours was.

You do owe something. If you look at your monthly mortgage statement, you’ll see that part of your monthly payment goes to the principal while the remainder goes to interest. Which stands to reason – at the 29-year-and-11-month mark, you’d obviously have paid off almost all the original $120,000 principal. Which means that early in the mortgage term, you’ve paid off almost none of it. Here’s a sobering chart that shows how much of the principal you’ve paid down at different points throughout the life of your loan:

Even a few years in, you’ve barely made a dent in the principal. It’s not until you reach the ¾-mark of the mortgage term that the house is more yours than the bank’s. If you think this is unfair, take it up with God for making mathematics work the way He did. Or find a rich uncle to lend you money interest-free.

Anyhow, back to your problem. Five years in, you’ve reduced the principal by $8,334.77, leaving $111,665.23 to go. (Trust us on this. Or just go here.) If you short-sell the house for $105,000, you’re out $6,665.23.

Plus you’re out your $30,000 down payment. Plus the realtor’s fee and closing costs, which are around 6% of the purchase price, so say $6,300. And don’t forget the 5 years’ worth of payments you already made.

Total outlay? $86,132.83.

Worst deal ever? No. Again, always look at opportunity cost – what you would have spent otherwise. Keep in mind that you paid that $86,132.83 over 5 years, and most of it is the mortgage payments you already made. That’s important because had you never bought the house, you would have had to spend something close to those mortgage payments anyway, on rent. Assuming that rents and mortgage payments are similar, you can ignore the $43,167.60.

So your 5-year experiment in overextending yourself with a house cost you close to $42,965.23, or $716.08 a month.

But again, opportunity cost. What’s the alternative to selling short?

If you walk away from the house and the bank forecloses on it, that means you probably let it fall into disrepair, or worse – after all, you’re no longer living in it and have no incentive to make it look good for a buyer. Industry standard is around a 20% discount for bank-owned properties – the bank probably won’t bother putting any money into an abandoned house, and will entertain the first solid offer that comes along just to get the house off its balance sheet.

A 20% discount means the bank will sell the house for around $84,000. Just because you ran away, doesn’t mean they won’t catch you. While you’ve reduced your principal balance to $111,665.23, that means the bank can come after you for a $27,665.23 deficiency judgment. They’ll win. Add that to the $30,000 you put down originally, and that’s $57,665.23.

In this example, selling short will save you $14,700 vs. walking away. Nor will it damage your credit quite as badly, nor will it label you a deadbeat.

*Most people who got in a position where they had to sell short are in exotic mortgages, which is of course a symptom of the bigger problem. If you know that you’re going to have the exact same payment every month for the next 30 years, that’s a certainty that you should be thrilled about. Fixed expenses are far easier to account for than variable ones.

Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina. He runs ControlYourCash.com and recently wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. Buy the book here (physical) or here (Kindle) and reach Greg at [email protected].