Buying a Home: A Short Sale vs. A Foreclosure & What Is Equity? | Molly’s Money

August 28, 2014·

If this is your first time here, Molly’s Money is a regular series I write on this blog that includes ALL things personal finance – debt management, budgeting, home buying, savings, investment, etc. I am NOT a financial advisor, but I am married to one! These are just things that I have learned over the years as I struggled with my own personal finances and ultimately, became debt free in 2012. Got a question about money that you want answered? Leave it in the comments below or email me!

John and I bought and moved into a new home a few months ago and it was the first time for the both of us going through the home selling AND home buying process together. John had bought the house we were living in a few years before we even met… so it was my first time really learning everything there is to know about the whole process. And man, there was WAY more information that I needed to know that I just knew nothing about.

A few of the things I really knew very little about was the difference between a short sale and a foreclosure and what home equity REALLY means. I’ve, coincidentally, had a few of you email me and ask about those similar topics as you’re on the hunt for buying a home… so I thought, “Well, I might as well include this in the Molly’s Money series!” I’ve already talked about things you should consider before buying a home and the breakdown of a mortgage… so be sure to check those out.

Now, I will say this up front, I realize that this isn’t the most interesting or riveting topic in the world… BUT, it’s one of those things that you learn as an adult and I really wish someone would have better explained to me earlier on. It would have made the process much less confusing for me. We did NOT buy a foreclosure or short sale when we bought our house, but it was something that we learned about and considered when we were looking at properties.

I will also say that this is BY NO MEANS an exhaustive explanation of a short sale, a foreclosure, and equity. This is just my 36,000 foot view and explanation of each to help you hopefully have a better understanding as you either get ready to look into buying a home for the first (or even second time) OR as you begin to plan to sell a home for the first time. 

What is a Foreclosure? 

When you buy a house, you take out a loan from the bank in order to buy that house. Duh. (Unless you’re rich and pay cash for it). Then, each month, you pay your mortgage to the bank. This is your repayment of that loan you took out. Well, say you stop making payments to the bank. And this goes on for a few months… and a few more months. And you end up owing the bank a lot of money. Eventually, the bank will take over the property (your house) and take it from you and sell it so they can (hopefully) get back their money. The owner of that home doesn’t get a dime.

Why Would You Buy a Foreclosure?

There are a ton of other things to consider with a foreclosure… but this is the basic gist.

What is a Short Sale?

In short, (no pun intended), a short sale is when the bank agrees to accept less than the TOTAL amount owed on a mortgage in order to AVOID having to foreclose on the house.

But WHY would a bank want to take less money than what is owed? Wouldn’t they just want to foreclose? NOPE! A bank would rather have a short sale than a foreclosure any time. A foreclosure can take a really long time, can be a painfully arduous process, and creates a huge expense for them. A short sale can save both time AND money.

A short sale is best done when the house you live in is worth LESS than what you owe on it (this has happened A LOT in recent years with the real estate market crashing) and when you’ve experienced “financial hardship” such as a job loss, decrease in your wages / salary, or even high medical expenses.

Why Would You Buy a Short Sale?

This is very similar to why you might buy a foreclosure… you can often save A LOT of money this way. BUT, I would give you similar warnings to that of buying a foreclosure. Damage, disarray, etc.

So, I would suggest working with a buyer’s agent that specializes in short sales, I would also make sure that you get a VERY good inspector, AND I would also find out if there are any other liens on the property you’re looking at. You don’t want to find out years down the road that someone has a stake in the property that you purchased at short sale.

And, contrary to the way it sounds, a short sale isn’t always a short process. It can sometimes take longer than 30 days to close on a short sale.

One of the upsides to buying a short sale or foreclosure is you have the opportunity to “flip” the house by making it over and making improvements and, ultimately, earning instant equity… 

BUT, What IS Home Equity?*

Say you buy a house for $150,000. When you bought the house, you put 20% down as your down payment ($30,000). Then, over the next five years, you paid $1,000 a month towards your mortgage – for a total of $60,000.* Part of that payment each month goes towards principal AND interest.

At the end of five years, you want to sell your house. You’ve paid in a total of $90,000 at this point ($60,000 in mortgage and $30,000 down when you bought it).

Your house appreciated in value and is now worth $165,000 and you were lucky enough to sell it for $165,000. $15,000 MORE than when you bought it.

So, $90,000 of what you paid into it PLUS $15,000 = $105,000 SUBTRACT interest paid… and what’s leftover… that’s your equity!

In essence, home equity is the amount of money or difference between the home’s fair market value and the outstanding balance on all of the debts or liens on the property (minus interest).

*EDITED TO ADD: This is a very general calculation of equity and does NOT really take into account interest. I’m keeping it super general for simplicity sake.

So, there you have it. Foreclosure. Short Sale. And home equity. It’s exciting stuff, I’m aware. 

Now’s your turn to sound off… is this something you knew anything about? Did you learn something? Have you bought a short sale or foreclosure?