One of the lasting effects of the real estate bubble and Great Recession is the growing number of professionals caught in the real estate devaluation of residential properties. In the past, home appreciation seemed to make any home mortgage safe for both the bank and owner, but the last few years have led to instances where the borrower can find herself 50 percent underwater on her home loan. In some instances, this has led a borrower to decide that the best option is to a sell the home, with the bank’s permission, for less than what is owed. The amount of loan left after the sale is commonly known as a “deficiency balance,” which may or may not be forgiven by the bank. A Look at Short Sales To understand how a short sale is perceived by a bank, a borrower must first understand that a typical bank considers a mortgage loan a contractual commitment by the borrower to repay the debt borrowed, regardless of what the house is worth. Even if circumstances make this nearly impossible for the borrower, the first reaction of a banker is to look upon a short sale as a breaking of the borrower’s commitment. The banker will see you as someone a bank took a loss on. This may indeed be harsh, and not an accurate viewpoint given today’s economy, but you should anticipate needing to explain what happened, if your banker is willing to listen. A short sale will have a huge negative impact on the individual’s credit score, regardless of whether the loan was current until the sale. According to an April 2011 CNNMoney article, a person with a 780 credit score will see a 160-point drop in his credit score, while a person with a 680 score before the short sale will see an 85-point drop. This is the same magnitude drop that you would receive from a foreclosure. The negative impact will occur regardless of how long you kept the mortgage current before the short sale. The Impact on Financing Like all derogatory credit items, this will continue to be present on the person’s credit for a number of years. The question we hear repeatedly from potential practice owners is, “How will this affect my ability to arrange financing?” or “How is this black mark on my credit score perceived by decision-makers at a bank?” The answer is not black and white. The effect depends on the flexibility of the credit standards of the bank looking at the practice acquisition loan, the circumstances surrounding the short sale, and other credit factors involved with the practice acquisition. The first area to investigate is the flexibility of the bank’s credit standards. Some banks require a minimum FICO score for their borrowers, with no exceptions. Typically, this score is around 650. If you have a short sale on your record, especially a recent one, your score will typically be below this minimum. Likewise, a bank may have a policy to never finance anyone with a short sale or bankruptcy on their credit report. If the bank is unwilling to bend, don’t get discouraged. Keep searching for a bank that will listen. Working with the Bank Once a bank will listen, the second factor a bank will look at is the circumstances surrounding the short sale. Be prepared to explain the causes of the short sale. If a person has the income to support the mortgage payment, but chooses to walk away simply because there is no equity in the property (strategic default), that will most likely be perceived by the banker negatively. If, however, the borrower needs to leave the area for a job, or experiences an interruption of income that led to the inability to pay, the resulting short sale might be viewed more neutrally. Was the loan kept current until the short sale? If so, this can mitigate the negative perception. It will be extremely helpful to your case if all other debts have been paid in a timely manner. If the short sale is the only blemish on your credit report, it will be easier to explain. If several other accounts were delinquent or charged off, you will probably find fewer banks willing to listen to the circumstances of the short sale. Bottom line: Be prepared to honestly describe what happened, and show how you were trying to work with your bank to resolve a difficult situation. Finally, the bank will be looking at the overall strength of the loan opportunity to mitigate the negative perception of the short sale. The bank will ask the following questions to gauge the overall strength of the loan request: Is the cash flow of the practice growing and healthy? Do you have the demonstrated skills to succeed not only as a great veterinarian but also as a great business owner? Is the purchase price of the practice reasonable? Are you purchasing the practice with a partner who has no personal credit blemishes? Do you have a terrific transition plan that shows you understand the practice’s competitive position in the market, and can successfully accomplish the ownership change without losing clients? If too many of these questions are answered in the negative, the short sale can probably not be overcome in the mind of the lender. But if everything is very positive in these areas, the short sale may not prevent you from obtaining the loan. A bank’s credit decision is always a judgment call. One potential weakness in one area can be offset by strengths in other aspects of the loan request. Be sure to highlight why this is a safe loan for the bank. Don’t shy away from talking about the potential negative short sale, but show why you are confident that the loan you are requesting will work well. David Lucht is chief risk officer for Live Oak Bank, based in Wilmington, N.C. Before joining Live Oak Bank in 2007 as a founding member, Lucht held high-ranking positions in many successful banking institutions. He was the chief credit officer, executive vice president and director for First Merit Bank of Akron, Ohio, where he was responsible for leading the turnaround in credit culture and performance of the $10.5 billion bank. This Education Series article was underwritten by Live Oak Bank of Wilmington, N.C. <HOME> 3/6/2012 4:25 PM
