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.
April 21, 2003
