If you’re shopping for a home, you’ll probably come across at least one property that’s listed as a short sale.

Many buyers are unfamiliar with this term and don’t know how a short sale works.

To understand the process, you have to understand the situation that the seller and the seller’s lender are in.

A short sale occurs when a lender allows a delinquent borrower to sell her home for less than she owes on the mortgage because the home is now worth less than what she originally paid.

A homeowner might want to do a short sale because he can no longer afford the mortgage payments and wants to avoid foreclosure (both have credit score implications).

Lenders might prefer a short sale to a foreclosure.

In foreclosure, not only do banks lose money they lent, they incur the costs of owning the abandoned home until it can be resold.

Vandals, squatters and angry former owners can cause significant physical damage to foreclosure properties. Even when this doesn’t happen, the property can fall into disrepair after going unoccupied for months or years.

These losses further decrease the property’s value and reduce the amount of the loss the bank can recover when it resells the home.

Banks don’t always agree to short sales, and the process of convincing them to do so can take months. Once the seller finds an interested buyer, the bank usually takes several more months to approve the sale.

Here’s a simple example of how a short sale might work.

In 2005, someone borrowed $400,000 for 30 years at 6% interest to buy a home with no down payment. The home is now worth $200,000.

Over the first five years, the buyer managed to stay current on the mortgage.

Using our mortgage amortization calculator, we can see she paid the principal balance down to about $365,000.

However, the buyer recently lost her job and hasn’t been able to pay the mortgage for the last 6 months.

She owes the bank the $365,000 balance on the mortgage plus 6 months’ worth of mortgage payments and late fees (about $15,000).

She’s found a new job, but it’s in another state. She wants to sell the house and start over.

If she sells the home, she’ll get $200,000 minus the 6% commission she’ll pay a real estate agent.

The net proceeds from the sale will be $188,000.

The difference between what the lender gets from the sale is the $380,000 the seller owes minus the $188,000 sale proceeds, or $192,000.

The lender is “short” $192,000.

As a potential buyer, you should only consider a short sale if you’ve in no hurry to move and if you love the property.

In a best-case scenario, the bank might approve the transaction in three months and you might take another month to close.

In a worst case scenario, you’ll wait for months only to find out that the bank rejected your offer, either because it changed its mind and wants to foreclose instead or because someone else submitted a higher bid.

Either way, the process will test your patience.

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