(This is part 3 of a three-part series. Read Part 1 and Part 2.)
This is the last of three articles on how borrowers who anticipate that they soon will be unable to make their mortgage payments can make the best of a bad situation. This article applies to borrowers who do not have significant equity in their homes.
Borrowers with no equity can’t open a credit line and draw on it to stay current on their mortgage, nor can they consolidate non-mortgage debts in a new mortgage. The options they have all require the concurrence of the lender.
But that does not mean that they have no leverage. The lack of equity makes foreclosure an unattractive option to the lender. With no equity, the lender who forecloses is not reimbursed for lost interest, foreclosure expenses or real estate sale commissions. Hence, the lender will be receptive to alternatives to foreclosure that will cost less.
The most attractive of these to the lender is a forbearance agreement, where payments are suspended for a period, to be made up by larger payments scheduled for the future. If forbearance works, it costs the lender nothing. On the other hand, if it doesn’t work, delaying the foreclosure will raise the cost. For this reason, a lender will only consider forbearance if convinced that the borrower’s problem is temporary.
A temporary reversal is one where, if you are provided payment relief for up to six months, you will be able to resume regular payments at the end of the period, and repay all the payments you missed within the following 12 months. If you believe that that is the case, prepare to document it.
If your problem is not temporary, the lender may still be receptive to alternatives that are less costly than foreclosure. The most attractive of these to a borrower, because it allows the borrower to remain in the house, is a loan modification that reduces the payment. This could be a lower interest rate, longer term, a different loan type, or any combination of these. Unpaid interest may be added to the loan balance.
Loan modification might be acceptable to a lender if the borrower’s income has been reduced to the point where the current payment is not affordable but a smaller payment is. A lender is likely to be most receptive to a loan modification if convinced that the borrower’s inability to pay is completely involuntary, and that modification would be less costly than foreclosure.
Borrowers with no prospects of a turnaround in their fortunes, who are unable to pay even with a loan modification, must resign themselves to giving up their houses. Even then, lenders will consider alternatives to foreclosure when they are convinced that borrowers are operating in good faith. If the borrower can find a qualified purchaser who will take title in exchange for assuming the mortgage, the lender is likely to allow it. This is called a “workout assumption.”
Alternatively, the lendermay be willing to accept either a “short sale” or a “deed in lieu of foreclosure.” In the first, the borrower sells the house and pays the sales proceeds to the lender. In the second, the lender takes title to the house. In both cases the debt obligation usually is fully discharged. Both a short sale and a deed-in-lieu appear on the borrower’s credit report, but they are not as bad a mark as a foreclosure.
Lenders are averse to making such deals with borrowers who have negative equity–their loan balance is larger than their house value–and who have the capacity to continue making payments but would like to stop. Such a borrower may view making payments on, say, a $350,000 mortgage secured by a house worth only $300,000 as throwing money away. They may try to rid themselves of their negative equity through short sale or deed-in-lieu.
While these options are less costly to the lender than foreclosure, lenders view borrowers as responsible for their debts, regardless of the depletion of their equity. How they respond depends on how convinced they are that the borrower’s problems are truly involuntary, and on the likelihood of success in collecting more if they go after the borrower for the deficiency.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
