Options for "Underwater" Mortgage Holders

Attorney Jean Shrem describes "strategic default" and other options for homeowners who owe more than their home is worth.

Over the last several years I have met with many homeowners who are in need of advice regarding their risks and options in disposing of their "underwater" properties (underwater is a slang term that refers to a property where the outstanding mortgage exceeds the current property value). 

When homeowners make the decision to walk away from their property, often despite their ability to pay the mortgage, this is termed a "strategic default." Usually a homeowner's decision to strategically default on his/her property is based on the fact that the mortgage not only exceeds the property value but also that the neighborhood has declined. 

What potentially defaulting homeowners wish to understand is what their risks and options are with regards to their liability to repay their lenders for their loans and what their obligations are to pay taxes on any borrowed money to the government once they no longer own the property. Most people contemplating a strategic default are either behind on their mortgage payments or are trying to decide whether or not to make their next mortgage payment.  

A strategic default is the current term used to refer to homeowners who are looking to dispose of their real estate without making a full payment to the bank. For most people their options are as follows:  Loan Modification, Short Sale, Deed In Lieu of Foreclosure and Foreclosure. 

A loan modification is when the bank agrees to modify the terms of the borrower's loan. My experience with loan modifications is that lenders are willing to reduce the interest rate for a short period of time and extend the loan term in order to bring down the monthly payments. I am not seeing any principal reductions. 

A short sale means that the homeowner is selling the property but owes more on the home than he can sell it for and is requesting that the bank forgive any deficiency from the sale. Short sales must be approved by the bank and are often delayed in closing or do not close at all. On average, one out of three short sale transactions close. Most lenders still require some sort of “hardship” in order to agree to a short sale. 

A deed in lieu of foreclosure is the process whereby a homeowner, with the bank’s consent, deeds an underwater property back to the lender instead of the lender foreclosing on the property. 

A foreclosure is when a lender follows the required process to take a property back from a delinquent borrower. According to DQNews, mortgage defaults and foreclosure concentrations are far greater in lower-cost neighborhoods where the median price is below $200,000.  These areas averaged 8.6 foreclosures per 1,000 homes in the first quarter. That compares with 5.0 foreclosures per 1,000 homes across all of California and 0.9 foreclosures per 1,000 homes for areas with median prices above $800,000.

In Alameda County, 2,373 homes received a notice of default (the lender’s first step in the foreclosure process) in the first quarter of this year, and in Contra Costa County, 2,778 homes received a notice of default during the same time period. There are 8.6 million houses and condos in California.

I have noticed some interesting trends regarding strategic default.  Underwater property owners like those in El Cerrito, Albany and Kensington tend to owe $50,000 to $100,000 more than their property is worth. The lower the deficiency (the amount a property owner is underwater), the more options that each property owner has. 

For example, for people who owe only $50,000, have some financial hardship (a typical loan modification requirement) and are still happy with their neighborhood, like those in El Cerrito, a loan modification might be a fine option. 

For people who have no financial hardship and have the funds to qualify for a second home, like many Albany and Kensington residents that I speak with, they can often buy a new home at current market value and then either walk away (let it go to foreclosure) from their inflated property (known as “Buy and Bail”), transfer it back to the bank (with a Deed In Lieu of Foreclosure), keep the property and rent it out, making up any kind of monthly shortfall from their bank account until property values rebound, or sell their home and write a check to make up any kind of shortage to avoid any credit impact. 

Most Richmond and Oakland homeowners that I speak with owe $100,000 to $300,000 over what their property is worth, and often the neighborhood has declined. These people tend to be less able to qualify for a second property loan, do not have the funds to make up any deficiency from a normal sale, and are mostly not interested in attempting a loan modification without a principal reduction down to current market values, or have already tried to do so and have been unsuccessful. These property owners just want to get rid of their real estate. 

Many of these people choose a short sale because they are having financial hardship (a typical short sale requirement) and hope that the credit impact will be less severe and they will be able to buy a home again in the next two to five years. 

A Short Sale, Deed In Lieu of Foreclosure and Foreclosure can all impact a person’s credit by up to 300 points and last for up to seven years.  However, people tend to rebound much more quickly from a short sale and can often qualify to buy a new home in much less time. 

One thing I have determined, though, for all of these property owners is that no matter what city they live in and how much they are underwater on their properties, only once they have obtained all of the necessary information and understand all of the ramifications and impacts of their option choices can they make the right strategic decision to meet their needs and accomplish their goals.

Richard Leigh August 01, 2011 at 03:28 PM
What about the tax implications for each strategy ? These need to be thoroughly reviewed prior to a decision.
Jean mills August 01, 2011 at 04:22 PM
Check out www.keepyourhomecalifornia.org - a new federally funded, state administered program with four unique foreclosure prevention plans - including principal reduction - to help California homeowners keep their home.
Gary Mundell August 02, 2011 at 02:52 AM
With decreasing home values, sellers are having to explore ways to cut costs when selling their homes. The real estate agent's commission is the largest cost incurred when selling your home. My Six Percent is a tool that guides a user step by step through the home buying / selling process. We provide access to all of the resources a real estate agent would provide at no cost to the user. My Six Percent - Because You Don't Need a Real Estate Agent www.mysixpercent.com
Todd Hodson August 02, 2011 at 11:19 PM
Great article, it gives an excellent overview of possible scenarios and options facing distressed property owners. I would take exception to the comment about not needing a Realtor. A good local agent provides expert advice on local market conditions and can provide valuable advice that can often net a seller well in excess of a Real Estate commission, not to mention expert negotiation skills and expertise in complying with required disclosures and local point of sale laws. Realtors approach each client's situation with care and a personal approach that cannot be duplicated using a one size fits all approach. In some situations you may not need an agent, but you may be doing yourself a disservice by not at least consulting one that you trust. Todd Hodson, Owner Marvin Gardens Real Estate, El Cerrito CA todd@marvingardens.com


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