One way to avoid foreclosure is with a loss mitigation option called a short sale, where you sell your home for less than what you owe on it. Your lender has to approve the short sale before it happens. If they do, the lender usually forgives the remaining balance owed and releases the mortgage lien on your property. Unfortunately, there are several types of fraud that can happen in short sales that you should be aware of. Here we’ll cover four common types of short sale fraud, what to look out for, and how to avoid fraudsters.
Written by Mark P. Cussen, CFP® , CMFC.
Updated October 6, 2021
If you are behind on your mortgage payments and it doesn’t look like you’ll be able to catch up quickly, then you may be facing foreclosure and eviction from your home. One way to avoid foreclosure is with a loss mitigation option called a short sale, where you sell your home for less than what you owe on it. Your lender has to approve the short sale before it happens. If they do, the lender usually forgives the remaining balance owed and releases the mortgage lien on your property.
Unfortunately, there are several types of fraud that can happen in short sales that you should be aware of. Here we’ll cover four common types of short sale fraud, what to look out for, and how to avoid fraudsters.
What Is Short Sale Fraud?
Short sale fraud is a type of mortgage fraud where either false information is used or valid information is withheld to convince a homeowner to do a short sale. Short sale fraud can come from homeowners, lenders, real estate agents and brokers, or other third parties involved in the sale. Homeowners and lenders are the most frequent victims of this type of fraud. Buyers and sellers should be cautious to guard against being cheated in these sales.
Watch Out for These Common Short Sale Scams
There are four main types of short sale fraud schemes that dishonest parties use to make a quick profit at either the seller or the lender’s expense.
1. Undisclosed Payments
If you want to try to sell your house for less than what you owe on it, the lender or lenders will have to agree to it beforehand. All short sale real estate transactions happen at the discretion of the lender. So if you have more than one loan on your home, then you must get permission from each of your lenders before you can begin the short sale process.
In a short sale with multiple creditors, the lenders are repaid according to a hierarchy. For example, your primary mortgage lender will get its money first, then the secondary lender, and so on. Secondary lenders are called junior mortgage holders. They may get little or nothing from the short sale, which means they may be hesitant to agree to it. To address this, the primary lender may offer extra compensation to the junior lender to get them to agree to the sale. While it’s not fraudulent to make such an offer, it must be disclosed in the loan settlement statement at the time of the sale. Failure to disclose such an arrangement is a form of criminal fraud.
Without this rule, there would be nothing to stop the primary lender from using extra compensation to convince other lenders to go along with a short sale they otherwise wouldn’t agree to. This is why undisclosed payments are considered fraudulent and why the primary lender can’t make secret payments to junior lenders under any circumstances.
This form of mortgage fraud occurs when an outside third party (usually a potential buyer) convinces both the homeowner and the lender that the property’s market value is considerably lower than what it appraised for. The homeowner then does a short sale, allowing the buyer to get the house at a steep discount. The buyer then turns around and immediately sells the property in the open market and makes a quick (and usually substantial) profit. Both the homeowner and the lender lose in this scenario.
3. Predatory Short Sale Negotiators
This foreclosure tactic occurs when a dishonest third party introduces themselves to a homeowner as a “short sale negotiator.” They offer to sell the home with the promise of getting a higher price for the home than the homeowner could get for themselves. In exchange, they charge a flat fee or percentage of the sale upfront. After they collect the fee, the so-called negotiator disappears whether they provided the service they promised or not.
To address this fraudulent misrepresentation, some states have passed laws requiring all short sale negotiators and coordinators to be licensed. If you are approached by a person or business who claims to be a short-sale negotiator, be sure to research them before making any commitment. You can check their reputation with the Better Business Bureau (BBB), the Consumer Financial Protection Bureau (CFPB), the Federal Trade Commission (FTC), and your state attorney general’s office. These sources allow you to see if the negotiator or business has had any complaints filed against them or any disciplinary history.
If you decide to move forward with a negotiator, get your agreement and any promises they’ve made in writing before you pay any upfront fees. And stay alert for anything they do or say that seems too good to be true or is out of the ordinary. This should be a red flag in most cases.
4. Non-Arm’s Length Transactions
This type of mortgage fraud happens when a borrower sells their home in a short sale to a friend or relative. Once the sale is done, the former homeowner buys back the home at a reduced price that’s less than their previous mortgage loan. Failure to disclose this strategy to the lender is fraudulent and illegal. It essentially amounts to getting the lender to forgive some of the home loan balance that they are legitimately entitled to receive.
For example, say a borrower gets permission to do a short sale and sells their home to one of their siblings for $50,000 less than the mortgage balance. The lender agrees to forgive the difference between the sale price and what was owed on the mortgage. Then the borrower buys the home back from their sibling for $40,000 less than what they owed on their original mortgage. If they didn’t disclose their intention to repurchase the home to the lender, the borrower has committed fraud. While they got to retain their house, reduce their mortgage debt by $40,000, and help a sibling make a $10,000 profit, the lender took a $50,000 loss. They were legally entitled to be repaid the full amount from the borrower.
Legal Consequences of Short Sale Fraud
Short sale fraud is a crime. It can result in fines, suspension of professional licenses, and even jail time. Whoever is responsible for the fraud may also face a civil lawsuit to help recover defrauded funds. The victim of a fraudulent short sale transaction can also be held liable if they cooperated with the scammer. Be sure to learn the rules of short sales before entering into one so that you can protect yourself from becoming an unwitting accomplice to a fraudulent transaction.
There are several forms of short sale fraud. Undisclosed payments, flopping, predatory third-party negotiators, and non-arm’s length transactions are common examples of this fraud. All are illegal and can result in fines, jail time, or loss of licensure for industry professionals.
If a third party offers to negotiate your short sale for you, be sure to check their license and reputation. You should also learn the finer points of doing a short sale so that you aren’t accidentally caught up in any form of fraud. You can consult your realtor or mortgage broker for more information on short sale fraud and how it might affect you. A local real estate attorney may also have legal advice to offer on this subject.