Options when you can’t pay your mortgage

As everyone knows by now, the economic meltdown has turned the housing market on its head, leaving millions of Americans faced with losing their homes. Can anything be done to keep people from being put onto the street?

The Federal government has set up programs such as HAMP (Home Affordable Mortgage Program), HAFA (Home Affordable Foreclosure Alternatives) program, and HARP (Home Affordable Refinance Program), but none has been as effective and far-reaching as hoped. But before delving into the specifics of HAMP, HAFA, and HARP (which I’ll save for another day), let’s start with the options borrowers and lenders have when borrowers can’t make their payments.

Foreclosure

This option doesn’t work for borrowers who want to stay in their homes. Foreclosure means borrowers are sued and eventually kicked out, and their home sold at public auction. More often than not, the lender ends up with the house then turns around and sells it – or tries to.

Another downside of foreclosure is that when the smoke clears, the borrower may still owe the lender money – the difference between what the house is worth and how much the borrower owed.

The good news though is that junior liens (like second mortgages) are wiped out. Still, the borrower ends up on the street looking for a new place to live. But if a borrower is so underwater (the house is worth far less than the borrower owes), foreclosure may be the only option. Borrowers who recognize this have been known to turn in their keys and walk away.

Deed-in-lieu of foreclosure

Foreclosure is avoided when this procedure is used, but the borrower still ends up losing the home. Deed-in-lieu amounts to a formal way of turning in the keys and walking away.

No lawsuit is necessary to pull this method off, but the lender has to be on board in order to do it. Because the public auction orchestrated through the foreclosure lawsuit is what wipes out junior liens, no lender is going to allow a deed-in-lieu if the home is burdened by junior liens because those liens would have to be paid off when the lender sells it. So for a deed-in-lieu to work, the home can’t have any baggage that comes along with it.

The trade-off the borrower ought to be looking for here is full and complete release from the debt the mortgage secures. Depending on circumstances, release from most of the debt (instead of all of it) might be acceptable too.

Modification

Without getting into specifics of HAMP, HAFA, and HARP, these are Federal modification programs designed to keep people in their homes. Any lender can modify its borrower’s loan, but lenders don’t keep their loans anymore. Instead, they sell them on the secondary market which packages them as securities and sells them to investors, meaning a borrower’s mortgage may be one in a package owned by a pension fund in East Chainsaw, Oklahoma. So, who does the borrower talk to about modifying? Thus the Federal programs.

Some modifications cut the rate of interest. Others extend the term to, say, 40 years instead of 30. Still others do both. Either way though, the full amount has to be paid back.

But cutting through the red tape, there’s no real reason for borrowers to shoot for loan modifications if they’re not able to pay. Will lenders modify loans for borrowers who’ve lost their jobs and have no income? No. Which means borrowers have to qualify for modifications to prove they can pay. Qualifying means credit scores, income, and debt are checked. For borrowers trying to modify so-called “liar loans” (borrowers who “stated” their income the first time around without having to prove it), this will be their first real shot at qualifying. Most programs also require borrowers to show their income, etc. has worsened since they got the loan they want to modify. But depending on how much they lied the first time around, maybe it hasn’t.

If a modification is pulled off, the borrower gets to stay in the house…at least until defaulting again. I’m not trying to be pessimistic here, but statistics say 20-30% of modified mortgages end up in default.

Modification plus note

An offshoot of a full modification is re-writing the mortgage by lowering the interest rate and knocking off some of the principal, which has the effect of lowering the monthly payment. But most lenders won’t be willing to eat the principal they’ve knocked off. Instead, they’ll require the borrower to sign an unsecured note promising to pay it back over time.

Why do this? To give the borrower a better chance to sell the home. If the home is encumbered by less debt, the sale price can be lowered making it easier to sell. So maybe the borrower will end up losing the home but on more honorable terms than being thrown out.

Short sale

If a borrower is underwater but not too far beneath the surface, a short sale may be the ticket. True, the borrower will be losing the home (by selling it) but will also be off the hook.

In a short sale, a lender agrees to accept less than the full amount owed on the mortgage. This option is for lenders who are practical – they see the handwriting on the wall. Usually, the borrower has been missing payments, knows it’s time to get out from under an unsustainable debt, and decides to sell. The problem is, if more is owed (but not too much more) than the home will sell for, how can the sale take place? It can’t unless the lender is on board. But more and more lenders (the savvy and prudent ones) realize it’s better to cut their losses and move on rather than go through the expense of foreclosure, take the house back, and still have to sell it.

In a short sale, a portion of the debt is forgiven. That’s good, right? Yes, but there’s a catch. To the IRS, forgiven debt amounts to income received. Which means the borrower will have to pay tax on it. And to be sure that happens, the forgiving lender will be sending the borrower a Form 1099.

Short sale with note

This option is like any other short sale except the amount the lender is shorted isn’t forgiven. Instead, the borrower signs an unsecured note promising to pay it back over time. Another good news, bad news situation. There’s no income tax to pay because the debt isn’t forgiven, but that means the debt doesn’t go away.

As with the modification with note procedure, this option allows the home to be sold, getting the borrower off most of the hook. But the “forgiven” debt still has to be paid.

- Morrie Erickson