So what is short selling? How can short selling significantly amplify risk? How does it work? Short selling was once considered a no-risk venture, at least according to bankers and other financial institutions. As the popularity and acceptance of short selling grew, however, that perception changed and now short sellers are routinely being referred to as "short sellers" or "short sellers' lawyers."
Short selling can be defined as the process of borrowing a smaller amount of the mortgage loan outstanding in an effort to either obtain a better interest rate on a loan or to settle the debt with the original lender. The borrowing of less money than is owed on a mortgage loan results in the borrower paying less in principal than originally owed on the loan. In short selling, the primary difference between this type of borrowing and other forms of leveraging is the leverage. Unlike conventional financing, selling one's mortgage note for less than the amount owed results in potentially larger profits. And since the sale of mortgage notes is a relatively new business, the industry is relatively untapped.
However, like any other industry, this has also been abused by unscrupulous short sellers. Short selling has come under increased scrutiny in recent months due to the foreclosure crisis currently impacting the United States. Because many traditional financing sources have either closed their doors or have implemented strict guidelines regarding who can participate, lenders have tightened their lending guidelines and, in some cases, have outright blocked short sales. These stricter measures have further increased the risk for the short seller because they limit the number of people that they can close sales with, which can result in loss of several thousand dollars in fees. Even worse, short sellers can lose their home if they are unable to qualify for a sale.
To answer the question, so what is short selling? The short selling definition is relatively simple. It is "the practice of selling a home (without the full loan obligation)". This is different from "short renting" because a short seller does not own the home; they are only acting on behalf of someone else, the lender. For example, when a short seller sells a property by buying it from the lender at the prevailing market rate, the short seller will not be responsible to make monthly mortgage payments (as would happen if the short seller sold the property to a real estate broker, who would make all monthly payments). Also, when a short seller sells property without actually possessing it (for example, by paying cash for it) the short seller is not responsible to pay the outstanding mortgage balance.
The short selling definition can be confusing, but there are a few main points that apply to all short selling transactions. First, as mentioned above, the definition applies to selling property "without the full loan obligation". In this case, the short seller is still responsible to make monthly mortgage payments, as would happen if the short seller sold property directly to a real estate agent, who would make all monthly payments. Also, in short selling transactions, the short seller is considered the "lessee" or owner of the property, rather than the lender or the real estate broker. In some states, this ownership is limited to a specific amount of time, such as a day, week, month, or year.
In order to qualify as a short seller in most states, the short seller must convince a lending institution or buyer that the current market value of the property is lower than the mortgage balance. In most cases, this means that the short seller must submit a balloon payment in advance of the closing date. The short seller must also include financial documents in the sale, such as income tax returns and financial statements, to prove that the mortgage balance is higher than the proceeds of the sale. The short seller must be a direct buyer in order to qualify, meaning that the lender must approve the sale of the property. If the lender approves the short sale, the transaction is considered a closed deal.
As soon as the buyer and the lender sign the sales contract and release the property to the short seller, the lender becomes the primary lien holder on the house. The lending institution is not required to re-list the property; however, if it does re-list the lender must give their borrowers notice in writing that they have agreed to and will perform the sale. This notification requirement is called a " Default Notice of Short Sale". This document also serves as a receipt, which is used by the lender to collect the money from the borrower for the deficiency balance.
A " Default Notice of Short Sale " must be sent to the borrower at the last known address of the seller. If the buyer does not respond or pay the deficiency in a timely manner, the lender will be forced to resell the property to an interested buyer. This is why it is important for buyers to know what short selling is in their state. Short selling can be very beneficial to the lender, but it requires the diligence of the buyer.
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