Foreclosures down, short sales up. Are banks getting smart?

Foreclosures are down to their lowest levels in nearly five years. One reason: Lenders are increasingly using short sales, instead.

The number of foreclosures in April fell to their lowest level since 2007 – and one reason is that lenders are getting smart.

Instead of foreclosing on people, a costly and lengthy process, they're increasingly using short sales to move people out of homes they can no longer afford. Short sales are not only faster than foreclosures, they often turn out to be cheaper. By forgiving part of the loan up front (a loss they would take anyway during foreclosure, lenders can get possession of a house faster and sell it before it has had time to deteriorate.  Homeowners get to shed their mortgage debt faster – and with less damage to their credit rating.

Short sales began outpacing foreclosures in some states late last year. Six states saw more preforeclosure sales – typically, short sales – than foreclosures in the fourth quarter, according to RealtyTrac, an online marketplace for foreclosure properties based in Irvine, Calif. In preliminary first quarter data for 2012, that total jumped to 12 states, including traditionally big foreclosure states like California and Arizona, RealtyTrac reported Thursday.

"I think we will see more states with short sales outnumbering foreclosure sales in the coming months," says Daren Blomquist, RealtyTrac vice president, in an e-mail. " In addition to the government incentives they can get for a short sale through the HAFA [Home Affordable Foreclosure Alternatives] program, lenders are realizing they can often recover more of their losses through a short sale than through foreclosure, and also that they can avoid any accusations of improper foreclosure procedures."

Bank of America, for example, announced this week that it will offer its short-sale incentive program, piloted in Florida, nationwide. Under the program, delinquent homeowners can get up to $30,000 in relocation expenses once they complete a short sale.

One challenge with short sales is that they're complicated. They involve negotiations among three parties (the bank, the seller, and the buyer) over what price the house will sell for and what loss the homeowner and the bank will take. These talks can drag on for months, with the buyer eventually walking away for lack of a clear decision.

Next month, mortgage-backers Fannie Mae and Freddie Mac aim to speed up the process with new guidelines that will require lenders to make a decision within 30 days of receiving a short-sale offer.

Accepting an offer is no trifling matter, because homeowners in a short sale typically owe more on the home than the home will sell for. Banks are likely to lose that difference whether they agree to a short sale or foreclose.

"Short sales are a more efficient way for the market to absorb the distressed properties and that should help pave a quicker path to market recovery," Mr. Blomquist says.

Still, they're a drag on the market, he points out. On average, short sale homes sell for 21 percent less than nondistressed properties. They're just not as much of a drag as foreclosure homes, which typically sell at a 34 percent discount.