Mortgage Payment Problems: What If You Can't Pay?

April 21, 2003 "I lost my job and have been making my mortgage payment from savings.  At some point, I will run out of savings.  What should I do? Some variant of this letter is appearing in my mailbox with increasing frequency. The problem is probably going to get worse before it gets better. Many homeowners faced with this situation do nothing, allowing the problem to overwhelm them when it hits. That is not smart. When you know a tidal wave is coming, you should minimize the damage by preparing for it the best way you can. UNDERSTANDING THE LENDER A good place to start is by understanding the position of the lender. A game plan for survival should be based on a realistic view of what the lender is likely to be willing to do. When a borrower is unable to pay but the problem is temporary, the lender has an interest in finding a way to help the borrower ride it out. A tool for this purpose is a forbearance agreement combined with a repayment plan. A forbearance agreement means that the lender suspends and/or reduces payments for a period, usually less than 6 months, although it can go longer. At the end of the period, the repayment plan kicks in. The borrower agrees 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. When successful, the borrower is brought current after a lapse, and the lender suffers no loss. However, a lender will only consider this approach if convinced that the borrower�s problem is temporary. The burden of proof is on the borrower. If the borrower�s problem is not temporary, the lender�s objective is to minimize loss. The ultimate remedy is foreclosure, where the lender goes through a lengthy legal process to acquire possession of the house. The lender then sells the house to recover the loan balance, unpaid interest and expenses -- provided there is sufficient equity in the property to cover it all. Lenders often do not come out whole on a foreclosure, and they do not like forcing people out of their homes. They look for alternatives to foreclosure that will cost them less, but they don�t want to be scammed by borrowers in the process. If a borrower�s income has been reduced to the point where she can�t pay the current mortgage but could pay a smaller amount, the lender might consider a loan modification. 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. A lender is likely to be most receptive to a loan modification where the borrower has little equity in the house, but wants to keep living there. With no equity, foreclosure would be costly. But the lender must be convinced that the borrower�s inability to pay is completely involuntary. If the borrower�s inability to pay is long-term and the borrower is resigned to giving up the house, the lender will consider several alternatives to foreclosure. If the borrower has a qualified purchaser who will take title in exchange for assuming the mortgage, the lender may allow it. This is called a workout assumption. Alternatively, the lender might allow the borrower to put the house on the market and accept the sale proceeds as full repayment, even though it is less than the loan balance. This is called a short sale. If the borrower is unable to sell the house, the lender might accept title to the house in exchange for discharge of the debt. This is called a deed-in-lieu of foreclosure. Knowing what a lender can do is useful, but it does not tell you what a particular lender will do in any specific situation. Lenders differ in how they respond to payment problems. It may depend on whether they own the loan or merely service it. It may also depend on who takes your call. I have always advised borrowers having payment problems to approach the lender before they become delinquent. Some have written back, however, to say that their lender won�t talk to them until after they become delinquent. This is a way that some lenders keep their servicing costs down. The impact on the borrower�s credit rating is not a consideration. It means that the borrower in trouble may have to press his case further up the corporate ladder. DEVELOPING A GAME PLAN Borrowers in trouble should develop a game plan before they become delinquent.  Step one in that process is to develop a realistic understanding of the position of the lender, as discussed above.  While some actions you can take on your own, such as selling your house, other actions have to be negotiated with the lender. You do better in any negotiation if you know where the other party is coming from. Step two is to document your loss of income. This will position you to demonstrate to the lender that your inability to pay is involuntary, should this be necessary later on. Step three is to estimate your equity in the house. Your equity is what you could sell it for net of sales commissions, less the balance of your mortgage.  This will help you develop a strategy for dealing with the lender. Step four is to determine realistically whether your financial reversal is temporary or permanent. A temporary reversal is one where, if you are provided payment relief for up to 6 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.  You must document the case for the reversal being temporary. If you cannot make a persuasive case that the change in your financial condition is temporary, the lender will assume it is permanent. Your game plan should take account of whether or not you have substantial equity in the house, and on whether the change in your financial status is temporary or permanent. Substantial Equity If you have substantial equity in your house, the least-costly action to the lender may be foreclosure. While foreclosure is costly, the lender is entitled to be reimbursed from the sales proceeds for all foreclosure costs plus all unpaid interest and principal. While foreclosure makes the lender whole, it is a disaster for you. Your equity is depleted, you incur the costs of moving, and your credit is ruined. Hence, you must avoid foreclosure, if necessary by selling your house. If your financial reversal is temporary, and you can persuade the lender of this, the lender may be willing to forbear -- suspend payments for a period, followed by a repayment plan. The lender will probably prefer to keep your loan, rather than foreclose on it, but only if convinced it is a good loan. The burden of proof is on you in this situation to demonstrate that the temporary payment relief will really work. If your financial reversal is permanent, sell the house before you begin accumulating delinquencies. This way, you at least retain your equity and your credit rating. Obtaining full value for your home may take some time -- you don�t want to be forced into a fire sale. If delinquency is looming, take out a home equity line of credit to keep your payments current. Little or No Equity If you have little or no equity, your bargaining position is actually stronger because foreclosure is a sure loser for the lender. If your financial reversal is temporary, and assuming you want to remain in your house, it will be easier to persuade the lender to offer payment relief than if you have equity. If your financial reversal is permanent, but not major, the lender may be favorably disposed to a contract modification that will permanently reduce the payments. If your financial reversal is permanent and major, the lender probably will be willing to accept either a "short sale" or a "deed in lieu of foreclosure". In the first, you sell the house and pay the lender the sales proceeds while in the second the lender takes title to the house. In both cases your debt obligation usually is fully discharged. They do appear on your credit report, but are not as bad a mark as a foreclosure.  The lender will turn a wary eye on borrowers with negative equity who have the means to continue making payments but would like 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. Copyright Jack Guttentag 2003

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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