CHAPTER 8
What If I Lose My Castle?
We’d all like to think that it could never happen to us—foreclosure only happens to other people. It only happens to people who made poor choices or just don’t work hard enough. But this couldn’t be further from the truth. To illustrate this point, I’d like to introduce you to Ryan and Kelly.
A hard-working couple in Southern California with a beautiful home and great jobs, they had purchased their home for $400,000 with a $40,000 down payment in 2006, two years before I met them. They felt very secure in every aspect of their lives, and the future only looked brighter when Ryan was offered a promotion at work. The position Ryan had aspired to and had studied so hard to someday achieve had become available. Ryan and Kelly celebrated this wonderful news and were thrilled at the fact that the new position offered a $50,000 increase in his current salary plus the potential for bonuses. The only downside was that they would be moving their family to Dallas from California to take the position. This was okay, they decided, since the cost of living in Texas was considerably lower, so the higher income would go even further.
After coming to the realization that the transfer was inevitable, they contacted their real estate agent to get their house listed for sale. Both of them felt as though the wind was knocked out of them when the agent provided their comparative market analysis—a tool used to determine how much their home is likely to sell for. The house they had paid $400,000 for two years prior was now valued at $280,000—at best. The housing market-slump had taken its toll on the area, and they were faced with four options—all of them unthinkable.
Option #1: Don’t accept the promotion—stay in California and weather the economic slump. The value in their home was likely to come back eventually.
Option #2: Take the job and move, but rent the house out for less than the mortgage payment and risk further depreciation.
Option #3: Have the agent negotiate with the mortgage company to take less than the amount owed—a short sale, which would ruin the couple’s credit.
Option #4: Let the bank foreclose on the property, also a damaging blow to their credit.
Ryan and Kelly had no idea which of these scenarios would be the least devastating. They were all bad. It was a shame to see a hardworking couple who had made good choices painted into a corner like that.
As excited as you probably were to buy your very first home, an equal degree of dread is going to be fixed on the threat of losing that home. The process of foreclosure not only means you have to move and give up your home; it also affects your credit score for many years, often more significantly than bankruptcy.
In this chapter, I provide you with potential solutions for fixing the problem before it is too late by bringing your late payments up to date and staying in good status with your lender. But when this is not possible, you may also consider a short sale (getting the lender to accept less than the balance owed to avoid foreclosure) or even bankruptcy as alternatives to losing your home.
Foreclosure Basics
Exactly what is foreclosure? Basically, it’s a process that starts if a lender is not able to get a mortgagor (borrower) to make timely payments. Your home is security for the loan. This means that if you fail to make your payments, the lender has a legal right to take the property away from you to satisfy the obligation. If this seems obvious, you should also know that many, many home buyers do not understand this basic concept. Today, many people believe—wrongly—that they are entitled to a home and to home ownership, and that if they cannot make their mortgage payments, lenders have no right to kick them out. Time for a reality check: When you sign a deed of trust or mortgage, you agree to the terms, including using the property as security for the loan. This is the only protection the lender has in the event that you cannot afford the monthly payments. It’s a hard reality, but it’s reality nonetheless.
Always remember, when you sign on the dotted line to finance your home, you are agreeing to a legal obligation.When a lender takes a home away from someone due to default, it repossesses the home, meaning it evicts a family from the property so that it can try to sell it to someone else to minimize their loss. In the same way, lien holders other than primary lenders can also force payment by placing liens on homes. These lien holders can include second mortgage lenders, contractors, home owners’ associations (HOAs), individuals winning court judgments, and federal or state tax agencies.
Foreclosure by judicial sale is the formal name for most foreclosures. This can be filed in every state and involves the sale of property for the lender to get all or part of the balance owed. If any equity is left over after costs, the original borrower/homebuyer will get those proceeds. This is also a court-ordered legal proceeding, and the costs can be quite high, so even if you have equity in your home, by the time the process has been completed, a lot of that equity will be used up by legal fees and costs.
To decide how much is payable under foreclosure, lenders use acceleration. Under this process, the lender declares the entire debt to be in default, so that it is immediately due and payable under the contract’s terms (the debt is accelerated and repayment demanded immediately). This debt will also include unpaid property taxes and accumulated interest and late fees, in addition to the outstanding balance on the loan. Acceleration clauses are included on the vast majority of mortgages. The lender—or, when property is sold within the procedure of foreclosure itself, the new buyer of the property—next orders the original borrower to vacate the home. If necessary, an eviction is filed so that the occupant can be legally required to leave.
Because it is possible that many unknown liens might exist on foreclosed property, the primary lender normally orders a title search and is then required to notify all people, agencies, or companies with liens. This due process gives junior lien holders the opportunity to appear in a court proceeding if applicable, or to file a claim asserting their rights. If a federal lien (usually held by the IRS) applies, the primary lender is required to file 25 days’ notice of a pending sale. If this is not done, then the IRS lien stays with the property and its new owner, even after the sale has closed. (So if you ever buy a property in a foreclosure sale, you need to get your own title search even if the original lender tells you that the property search was conducted.)
A person who has been notified of a foreclosure by the lender can ask the court for a temporary injunction. The person can also challenge the validity of the debt by claiming that the lender is not a valid party to the original obligation, and thus the debt is claimed to be invalid. If this seems like a far-fetched idea, you should know that such actions have been successful in recent years and in some states.
It’s more likely that if you go through foreclosure, your home is going to be repossessed and sold, perhaps through an auction. Depending on the strength or weakness of real estate in your area, the auction price might be lower than the debt level. If you do not carry private mortgage insurance (PMI) insurance (required by lenders, usually when equity is lower than 20 percent of the sales price), does this mean the lender is simply out of luck? No. It is likely that when the sale price of an auctioned or resold property does not cover the debt, they will go back to court and file for a deficiency judgment against you. This places a lien on any other property you own (or buy in the future) and obligates you to repay the difference to the lender. The deficiency would apply, however, only if the mortgage is a recourse debt (meaning the lender is entitled to sue for the deficiency). Many owner-occupied residential loans in the United States are nonrecourse, meaning the lender cannot go after you once foreclosure has been completed. However, even if your first mortgage was nonrecourse, it is possible that a refinanced mortgage or equity line of credit are recourse loans; in these cases, lenders can (and will) try to collect all of the money owed. If you end up not having to repay a deficiency, the amount could be federally taxable to you (this rule was suspended by President George W. Bush on deficiencies through 2012, but check the current rules).
Avoiding Foreclosure
The process of foreclosure is daunting and stressful, of course, but many people can avoid having to go through it by taking preventive steps.
Don’t just walk away from your home. Always consider the many possible ways you can avoid foreclosure.1. Get in touch with your lender if you are having problems. Once you realize that you are not going to be able to keep up your payment schedule, the first step you should take is to get in touch with your lender. This is counterintuitive. Many people fear that a lender, upon hearing that you are having trouble, will immediately file foreclosure. This is not true. If you get in touch before you are late on any payments, you have a better-than-average chance of finding a cooperative ear and constructive alternatives. Don’t ignore the problem, hoping it will go away on its own. The majority of people who go into default have made no contact with the lender, so an aura of distrust defines the confrontational nature of the process. By expressing your desire to keep your home and to work with your lender to develop alternatives, you have a good chance of coming out of the difficult times intact. Remember, the lender does not want to foreclose. Often there is no choice because the borrower is avoiding contact.
2. Refinance for an extended period or a lower rate. When you talk to your lender, look for rational and practical alternatives. If your problem stems from the increased rate in an adjustable-rate loan, find out if your lender is willing to reduce your rate and move you to a fixed-rate mortgage. You can reduce payments by extending the repayment plan—in other words, starting over with a 30-year plan—which increases your long-term interest expense but also helps you to keep your home.
If your current lender cannot help you, consider asking other lenders if they can help you refinance your present loan. Do this before you fall behind in your current mortgage payments. It is much easier to get a new loan if you have never been behind in your payments.
3. Bring the account current by tapping other resources. You should want to avoid foreclosure if at all possible. Your home is the biggest purchase you are likely make in your life, and it is also your most important asset, one worth preserving if possible. Consider all available alternatives. Tap your 401(k) retirement fund either through a withdrawal or as collateral for a loan. Talk to family members. If you are due for a good-sized inheritance in a few years, your parents might also be willing to help you with a loan or gift today. Also consider talking to your employer. If you have a track record as a responsible employee who is valuable to the organization, your employer might also be willing to make a loan to you.
These steps make sense only if you can see how a revised plan will allow you to keep your home and also keep your financial head above water. But if, realistically, going further into debt only delays the inevitable, don’t ask others to help you, and don’t tap into your retirement account. Be sure you have a realistic plan for repaying borrowed money and that your plan makes sense.
4. Ask about loan modification as an alternative to defaulting. Many people have found themselves in a position where their loan balance is higher than their home’s market value. This negative equity is very difficult to contend with because, at the time, it might seem that there is just no way out other than walking away. But there might be another path worth following. If you live in an area where values have fallen, you might be a good candidate for a loan modification. Before asking for a modification, you should know that this can adversely affect your credit rating. As part of your inquiry, ask your lender how modifying your loan’s balance and terms will affect your credit.
Loan modification has become popular now that the subprime crises and accompanying housing bubble have become realities. Many lenders have had to face the difficult task of foreclosing on record high numbers of homes or agreeing to modification as a somewhat less expensive step. A modified loan with a lower interest rate or even a temporary suspension of interest payments helps homeowners keep their homes during a tough period (such as unemployment or underemployment, for example). An even more drastic step includes reducing the amount of loan that is due along with lower interest rates, in order to reduce the monthly payment. The intention of loan modification is to avoid foreclosure. The lender does not want the expense of having to foreclose and resell homes, and in comparison the cost of loan modification could be a better choice for them. A 2009 study by the Federal Reserve Bank of Boston revealed that only 3 percent of delinquent homeowners received a loan modification.10
Some lenders will play hardball, thinking they can make more profit by foreclosing and selling, but in markets with a glut of depreciated homes, that is not always the case. In such markets, it doesn’t hurt to ask for a modification. Banks may resist negotiating loan modification due to the profit motive, but once the market situation gets worse in an area, they will be more likely to consider this alternative.
5. Rent out the home. If rental income will cover your mortgage, property tax, and insurance costs, or most of it, this could be a very practical solution that also helps you stay current on your mortgage payments. There may also be tax benefits, so talk to a certified public accountant (CPA) about the pros and cons of using your home as a rental property Be sure to take into account all of the responsibilities that come with being a landlord, and don’t forget to screen your potential tenants carefully, including their credit report.
6. Talk to a real estate professional about selling your home. If all else fails, don’t just let your lender foreclose. The damage this does to your credit is severe, and it makes it much more difficult to ever buy a home again. You may consider just biting the bullet and selling your home, regrouping, and waiting for the right time to buy again.
Evaluate your equity in the home to determine whether selling is a viable option. In any event, do not walk away from equity unless you are hopelessly underwater. Even then, consider all of the alternatives first.
7. Consider a short sale. This is a solution in which your real estate agent negotiates with the lender to accept as “payment in full” an amount below the current balance of your loan. In this situation, you must ensure that the agent you’re working with is skilled and experienced in negotiating short sales. Simply put, the agent who helped you into your home might not be the right guy for a short sale.
One Saturday morning, a gentleman named Mike called into my radio show. He was angry about his position, and very afraid to lose his home. Due to a combination of circumstances including a weak real estate market, the loss of a job, and uncovered medical expenses, Mike was in way over his head and facing foreclosure. I sympathized with him but also realized that he was not thinking clearly. The prospect gave him such deep anguish that he was willing to just walk away from his home rather than think through all options available to him. His delinquency was $5,000, a fraction of his stake in the home. Mike needed someone to calm him down and rationally take him through his options, and it happened that he came across my show just in time to find a beacon of light in his storm. Mike thought he had two options—walk away, or negotiate a short sale. In just a few minutes, I was able to find that Mike had a nice nest egg in a 401(k), but didn’t think he was allowed to touch it before retirement. Although there are some retirement plans that won’t, most of them will for the purpose of saving your homestead from foreclosure. Mike was skeptical—remember, he had already had his mind made up that there was no way out—however, he promised to call his 401(k) administrator on Monday to explore that option. It turned out that he was able to withdraw enough money from his 401(k) to bring his mortgage current and to put a little extra in savings to get him through the rough patch.
The moral of the story is this: If you are having problems keeping your mortgage payment current, foreclosure is not your only way out. Had Mike let his house go back or completed a short sale, it would take years for his credit to recover, not to mention the emotional toll his family would have taken as a result of losing their home. Mike, if you’re out there, I hope you’re doing well.
The problems with foreclosure are not just the negative hit on your credit score and the loss of your home. A couple of points that Mike and anyone else in his situation have to remember are: First, a short sale could result in your being taxed on the difference between the amount you owe and the settled amount. A moratorium was signed by President George W. Bush exempting taxation of short sales on primary residences until 2012. Second, a short sale is going to be a negative on your credit report, identified as “creditor settled for less than amount due.” This is better than foreclosure, but it is still a negative that remains on your credit report for seven years.
8. Look into bankruptcy as an alternative to foreclosure. Talk to a bankruptcy attorney to find out what happens to your equity and to a foreclosure process if you file. The filing could delay or prevent a foreclosure. One of the first steps that occurs in a bankruptcy is that a stay is placed on any collection proceedings against you, including foreclosure (late payments and fees can be included in bankruptcy, but the principal balance cannot). The lender cannot pressure you to sell your home, refinance, or bring payments up to date until you have gone through foreclosure, which may take up to three months or more. In your discussion with the attorney, be sure that you evaluate all of the benefits and consequences of filing, not just the foreclosure issue.
Bankruptcy may also involve tax consequences depending on the terms of your filing, the type of debt, and any negotiated settlements you make with your lender and other creditors. Your credit score will fall as a consequence, and this will remain on your report for 10 years. However, as a homeowner, you are at least partially protected even if the bankruptcy court liquidates all of your assets. Every state has a homestead exemption for real estate. This means that the maximum homestead is protected from all creditors, even if you owe more than your equity. This does not extend to the loan you signed when you bought your home, but does exempt your equity from other lenders filing claims in bankruptcy court.
For example, in California a single person has a $50,000 exemption and married couples have $75,000 (disabled and those over 65 exempt up to $150,000). Florida, Texas, Kansas, and Oklahoma have some of the broadest homestead laws. Texas imposes no dollar value on homesteads up to 10 acres outside of a city’s corporate limits. Kansas and Oklahoma has a similar rule, but it applies to up to 160 acres. You should check your state’s homestead law and its limitations with your bankruptcy attorney and determine how much of your equity will actually be protected under prevailing law.
When Foreclosure Is Inevitable
Once you have exhausted all of the possibilities, you might realize that you are simply in over your head. With little equity or even negative equity, you may not be able to find relief in any process other than foreclosure.
Know when to say “when.” You can’t squeeze blood from a turnip, and you might realize that in this case, you’re the turnip. I’ll never forget Andy and Sharon, clients who were once at the top of their financial game. Both had promising careers and plenty of income for their lifestyle, and they bought a home they thought they could afford—at least until Andy was laid off. Unfortunately, this couple also had a great deal of pride and simply didn’t know when to say when. They had difficulty facing the fact that they could not afford to keep their home. They finally faced reality, though, and went through foreclosure. Oriented as they were to success, though, they got through the tragedy of their loss, regrouped themselves, and relied on their mutual love, on faith, and on their work ethic. They got their life back, as well as their good credit score, and today are back on the positive track.
As Andy and Sharon discovered, foreclosure should never be taken lightly. If it’s inevitable, it has to be confronted and dealt with as soon as possible. If you end up having to go through this painful process, you are going to need to work with a skilled attorney and with a tax expert as well. Foreclosure is going to end up as one of the worst negative items you can have on your credit report, so letting this happen to you should be a very last resort. Remember too, even once you get through the foreclosure, if the lender does not get its full balance, you may find yourself named in a lawsuit for the difference. When this happens, you lose your house, your credit score plummets, and then you are sued. These reasons are why foreclosure should be the last resort.
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