(This is Part 1 of a three-part series.)
Payment problems are on the rise. In this series of three articles, I consider how borrowers who anticipate that they soon will be unable to make the payments can make the best of a bad situation. This article applies to borrowers who have significant equity in their homes
Don’t Practice Denial: If you stick your head in the sand and allow yourself to miss payments, you lose one potentially valuable option: the ability to stay current by raising cash against your equity. So long as your credit is good, you can take out a second mortgage or do a cash-out refinance on your first mortgage. Once you miss payments on the first mortgage, however, you lose this option. No one wants to make a second mortgage to someone who can’t make the payment on the first.
Don’t Expect Help From the Lender: If your ability to pay is impaired but you have substantial equity in your house, informing the lender of your problem is risky. Some lenders will respond positively to help you find a solution, but too many others won’t. A common response is, “Come back and see us when you have missed two payments.”
The brutal fact is that if you have substantial equity in your house when your income drops, you and the lender are in a conflict situation. Your equity protects the lender against loss (equity is the current market value of your home, less the balance of all existing liens against it). If the lender forecloses, your equity covers not only the loan balance, but also the foreclosure expenses and unpaid interest. The last thing the lender wants, when your ability to pay has been impaired, is to have this equity depleted by your taking out new loans.
Telling borrowers to return after missing two payments removes the danger (to them) of equity depletion. When borrowers return after missing two payments, their credit is shot and they can’t borrow anywhere else.
Using a HELOC to Make the Payment: Borrowers who are current on their mortgage can stay current by borrowing against their equity. The best instrument for this is a home equity line of credit (HELOC), which you can draw on as needed. This doesn’t solve your problem, but it buys time while you find a solution. Within the limited time you have available, your financial situation must recover to the point where you are able to service both loans.
You can estimate how much time you have by dividing 90 percent of the line by your monthly payment. If your line is $20,000 and your payment $500, for example, you have about 36 months.
Selling the House: If you aren’t confident that your income will be restored during the period a HELOC can keep you afloat, sell the house. At least then you realize the equity in cash. You may still want to use a HELOC to keep the first mortgage current while you sell the house. Obtaining full value sometimes takes some time and you don’t want to be forced into a fire sale.
Forbearance Agreement: If your financial stringency is temporary, but you have lost the ability to borrow by falling behind in your payments, there is one other possible option that will keep you in the house: a forbearance agreement with the lender. Under such an agreement, the lender suspends and/or reduces payments for a period, usually less than six months, although it can go longer.
At the end of the reduced-payment period, a repayment plan kicks in. You agree to make the regular payment plus an additional agreed-upon amount that will cover all the payments that were not made during the forbearance period. The repayment period is usually no longer than a year.
If the plan is successful, you will be brought current and the lender will suffer no loss. However, the lender will only consider this approach if he or she is convinced that your problem is temporary. The burden of proof is on you to document the case.
A forbearance agreement is a second-best solution because you won’t get one until you are delinquent. The lender will dictate the terms because you have no place to go.
Borrowers with equity who are unable to pay their mortgage because of an excessive burden of non-mortgage debt have another option: debt relief under a Chapter 13 bankruptcy. This will be discussed next week.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
