Strategic Mortgage Defaults: A Growing Trend – A Response

In reviewing the article entitled “Strategic Mortgage Defaults: A Growing Trend” in a December 2009 newsletter, I felt compelled to clarify a few issues with regard to mortgage delinquency, bankruptcy, short sales and, ultimately, homeowner choices.  Having accurate and full knowledge of the processes and options available is a crucial first step in decision-making, particularly for folks who are facing economic distress and consequences that will affect them for possibly seven to ten years after a course of action is pursued.

Myth #1: If your mortgage is greater than the value of your house, your best/only option is to stop paying and walk away.

Truth: In reality, you have many options, the most natural of which is to continue paying the mortgage (personal responsibility: a shocking concept!).  Values have declined all over the country, typically between 30-40% from their 2006 highs, but this is irrelevant to the obligation the homeowner made to repay the loan when she bought the house.  We all lose money on our investments from time to time, and primary residences/real estate is no exception.  If there is a true hardship, the owner simply cannot remain current and there is negative equity, other options include loan modification, forbearance, short sale, deed in lieu, bridging any gap between sales proceeds and outstanding principal balance with personal savings, leasing, leveraging other assets or lines of credit, personal loan from family/friends and chapter 13 bankruptcy.  Depending on the circumstance and state law, any of these options may prove more beneficial to a homeowner than simply allowing the lender to foreclose.

Myth #2: Following a short sale, the homeowner remains liable for the deficiency.

Truth: Most lenders waive the deficiency as part of the approval process.  This sometimes requires additional negotiation and proceeds than an original offer the lender would otherwise accept to release its lien, but once the lender determines that the net sales proceeds approximate the value of their collateral and that the seller has no other assets to contribute, they will typically agree to a short sale with no recourse back to the borrower.  In non-recourse states like Arizona, lenders are not allowed to pursue homeowners for the deficiency for purchase money loans at any time.

Myth #3: There is no meaningful difference on your credit between a short sale and a foreclosure.

Truth: Actually, experienced negotiators are frequently able to convince the lender to report ‘paid in full’ on the approval letter issued, or to correct the error of ‘settled for less that what was due’ (or similar language) on the credit report after settlement occurs.  This will have a net POSITIVE effect on an individual’s credit.  FNMA has issued guidance that it will not allow homeowners to purchase homes for two years following a short sale, but it is not clear that a paid in full designation would trigger that two year waiting period.  Even in the absence of a favorable credit result, the adverse impact of a short sale parallels a foreclosure only after the period of delinquency exceeds four months.  Otherwise, it is like any other settlement or charge off – the impact would be limited to two to five years (rather than seven in the foreclosure instance).  In any event, completing a short sale would not force homeowners to check “yes” to questions from employers or others that ask the prospective applicant whether they have ever experienced a foreclosure or deed in lieu.

Myth #4: A foreclosure through a ‘strategic mortgage default’ has less impact on your credit than a ‘normal’ foreclosure.

Truth: For better or worse, credit bureaus do not discriminate the reason behind a foreclosure or default.  Likewise, late penalties and fees apply following any default, irrespective of rationale.

Myth #5: A strategic mortgage default/foreclosure is a better option than a short sale.

Truth: This is almost never the case.  Homeowners have the same ability to stop paying their mortgage and stay in the home if they so choose, as well as the same tax benefits/exemptions on primary residences, with a short sale as with a foreclosure.  Apart from that, the cost/benefit analysis actually runs the other way: (i) short sales net the lender more proceeds than foreclosures (this is true almost by definition, as the lender will not approve a short sale if they feel a foreclosure will return higher proceeds), thereby mitigating any deficiency judgments or adverse tax consequences (to the extent either apply) to the homeowner; (ii) in many instances, a lender will waive a deficiency judgment altogether in the short sale, which of course does not happen in a foreclosure context; and (iii) there is or can be a positive credit impact with a short sale, and at the very minimum not as negative an impact as with a foreclosure (which is always negative and can have other, secondary consequences for employment applications, etc.).

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