Walking Away From A Home And The Loan(s)
Strategic default, or "walking away" from a home and it's loan is a decision some people have been making, actively choosing to accept the negative credit impacts and possible stigma of foreclosure rather than continuing to pay a loan significantly greater than their home's value. How bad will the credit ding be? 100-200 points on credit reports is likely in the short term, if all other accounts are kept current in the years following, credit will rebuild over a period of two to three years. Lender guidelines for the purchase of a new home will vary, it currently will take 3-5 years after a foreclosure before a new home can be purchased. Those guidelines can, and do change, the guidelines are also different between different lenders and investors.
There are many arguments, both pro and con, regarding the ethics and/or morality of choosing not to pay on a contract that was entered into voluntarily, the decision is a personal one and that aspect of strategic default won't be covered here, just the practical aspects. Loan default caused by financial hardship also won't be covered, that's a completely different subject with it's own solutions.
How underwater is your home?
Home values in different parts of the country vary widely, there's no practical way to assign dollar values to a loss in property value, we have to use percentages to have some element of conformity. So, "My property is $20,000 underwater" won't work, but "My property is worth 20% less than the loan amount" will more closely reflect different area property values.
I don't believe there is any long term financial benefit to a strategic default if property values have dropped less than 20% or so. The costs and effort of moving, the increased costs of credit and the possibility of lender deficiency judgments just don't make it an attractive option, it's undoubtedly better to ride out the price decline knowing that property values will rise once again, although it's going to be at a slower pace than the mid part of this decade.
If the value of your home has dropped significantly more than 20%, leaving you with a loan balance much, much higher than your homes value, you'll probably find the following information useful.
What happens when you stop paying a home loan?
Most loans have a grace period after the payment due date. If the payment is due on the 1st, that payment usually isn't considered late until around the 15th. On the 16th,
if no payment has been made, the loan could be considered in default and the foreclosure process could begin. Most lenders won't do that. On the 16th, your lender will
send a letter reminding you that you need to make a payment, they'll also probably call you. Most lenders will not initiate any kind of foreclosure process until 3 payments
have been missed, and it could take quite a bit more time than that depending on lender/loan servicer workload. The actual foreclosure process and timeline varies by
state law, but in most states there is an initial document recorded and mailed to you declaring the loan in default and giving you the dollar amount and time to cure the
default, then after the time to cure has passed a second document will be recorded and mailed to you scheduling a foreclosure auction/public sale. After the foreclosure
auction, the lender or a third party bidder will obtain title to the property subject to owner rights of redemption available in some states. Either after the
redemption(if available) or the foreclosure auction, the title holder will seek possession of the property(eviction).
If a lender/servicer is right on top of every file, the combined timeframe for default/foreclosure in a short timeframe state is a minimum of 5 months with no payments,
the foreclosure process in some states can take up to a year.
What happens when you have two loans?
A home loan is a contract between a lender and borrower which will normally include a Promissory Note and either a Deed of Trust or a Mortgage. The promissory note is your promise to repay, the deed of trust or mortgage is a security instrument providing the collateral for the loan. Why is this important? Foreclosure on a property by one lender does not wipe out other notes, foreclosure by a senior lender simply removes the junior liens from the property title.
In a situation where a borrower received an 80/15/5 loan, or 80% first loan/15% second loan/5% down payment and the property value has now dropped to 20% below the original
purchase price, what's likely to happen if the borrower stops making payments to both lenders?
The second lender is unlikely to pursue foreclosure because they'd incur the expense of foreclosure, have to reinstate the first loan and keep it current, then incur the
costs for property rehab, marketing and costs of resale. That doesn't make financial sense unless they believe the property value to be much higher.
The first lender is the one who is likely to foreclose. With a 20% drop in property value, they are at a break-even point. They'll incur carry costs, property rehab,
marketing and costs of resale, but they will recover most of their loan amount.
After the first's foreclosure, the second is now an unsecured debt owed by the borrower, similar to a credit card debt. Will they pursue that debt or will it just be written off? That's a big unknown which will depend on the lender, state laws and whether your financial situation appears strong enough to justify the effort. If your state laws allow the second lender to pursue you, settling the debt for a percentage of the amount owed might be a practical solution.
What about Deficiency Judgments?
Deficiency judgments occur when a lender loses money through the non-completion of a contract (loan) and the lender chooses to sue the borrower for the loss. Some states do not allow deficiency judgments for any loss a lender may suffer on a single family primary residence home, other states protect borrowers from deficiencies related to purchase money loans, and some allow lenders to obtain a deficiency judgment for any loss they may suffer related to a home loan. This is a very important facet, and you should seek legal advice from an attorney in your state regarding your exposure.
Tax exposure
In a situation where lender(s) have decided not to pursue a deficiency, but instead are just going to write off the debt as uncollectable, the lender should issue a 1099-C which informs the Internal Revenue Service that the lender has written off the debt. From the I.R.S. perspective, debt that has been cancelled is the same as income, meaning income tax is owed on that phantom income. Realizing this isn't an intended purpose during a significant housing bust, The Mortgage Debt Relief Act of 2007 was passed to eliminate taxation on debt forgiveness related to a primary residence through 2012. IRS Link There are restrictions and limitations, so it pays to read carefully and perhaps also consult with a CPA regarding those liabilities.
Whatever your choice may be, this information is not tax or legal advice, it's strictly background information about the foreclosure process and it's ramifications. You are strongly advised to obtain legal and tax advice from qualified professionals in your area before taking actions of any kind.
