Financial experts commonly advise avoiding foreclosure when possible. Foreclosure devastates your credit history and rob you of any equity paid into your home. However, in some cases foreclosure is a foregone conclusion. Owners facing such proceedings should understand the ramifications on their mortgage liability.
When a home is financed, the borrower makes a commitment and agrees to pay back the loan. The purchased house represents collateral that secures the loan. For this reason, banks and lenders avoid letting homeowners sell their property for anything less than the outstanding balance owed. Lenders aggressively hold this position, wary of any borrowers looking for an easy way out; too many forgiven homes could become a trend, and the bank then loses its loans.
Foreclosure As an Option
The legal proceeding of taking the house as collateral, called foreclosure, occurs when a homeowner defaults on his mortgage. Some owners in dire straits may consider foreclosure as a walk-away situation; the bank gets the home to sell, and the owner no longer needs to try to pay mortgage bills he can’t pay. However, foreclosure frequently results in a defaulted home being sold for far less than the loan balance or what the house might be worth. The bank can still collect the remaining loan balance unpaid by the house sale.
The remaining balance on a mortgage after the collateral sale (the home) is called a deficiency balance. The amount frequently exceeds the default borrower’s remaining assets and can force him to consider bankruptcy. Although bankruptcy can provide a legal shelter, filers must understand the difference. Chapter 7 bankruptcy sells remaining assets first before discharging debt. Chapter 13 bankruptcy orders a court-approved payment plan, deferring debt still owed.
An alternative to foreclosure and deficiency balances include trying to get the lender to agree to selling the house for a lower price, called a short sale. When foreclosures are plenty in a region, banks might be inclined to agree to short sales to get collateral off their books and liquidated into cash. This can financially be a far better business decision than selling the house at a far lower price in a foreclosure sale.
However, unless homeowners bind the bank to an agreement to forgive the remaining debt not settled by a short sale, the lender can still pursue collection.
To be worthwhile to the borrower, the leverage of quick cash via a home sale needs to be traded for a forgiveness of remaining debt. Otherwise, there’s no difference between the short sale and just rolling over to foreclosure.
Walking Away Doesn't Always Work
Between 2000 and 2010, some owners who were deep in debt compared to their home market values began walking away from their homes. This seeming freedom turned out to be an illusion. Although the banks did seize the properties to have some recovery, they simply delayed chasing deficiency balances because there were so many foreclosures at once. Eventually, lenders began to pursue collections again. Walking away worked only in states where the law bars collection on loans for a primary residence.
Credit Rating Impact
A foreclosure deficiency balance and default consistently destroy credit scores. Missed payments are reported within 60 days, and defaults can be filed as early as 90 days from an overdue payment. Court lawsuits end up placing the final nail in the coffin with the label foreclosure on the credit record.
Funny Business Not Allowed
Some owners have tried to finagle short sales or foreclosures with relatives in the wings. The approach lets the bank take the defaulted house, a relative buys the home without declaring the relationship, and sells it back to the original owner at a discount, thereby seemingly getting rid of the bank loan and lender. This is considered financial fraud and a felony.
- Bills.com: Foreclosure Short Sale
- Bills.com: Letting a Home Go Into Foreclosure
- U.S. Foreclosure Law: Arizona Foreclosure Law Summary
- MSN Money: Facing Foreclosure? 9 Options
- LegalMatch. "Foreclosure Alternatives." Accessed June 20, 2020.
- Cornell Law School Legal Information Institute. "Foreclosure." Accessed June 20, 2020.
- NOLO. "Homeowners’ Associations (HOAs & COAs)." Accessed June 20, 2020.
- Consumer Financial Protection Bureau. "How Does Foreclosure Work?" Accessed June 21, 2020.
- U.S. Department of Housing and Urban Development. "Are you at risk of foreclosure and losing your home?" Accessed June 21, 2020.
- Cornell Law School Legal Information Institute. "Equity of Redemption." Accessed June 21, 2020.
- FindLaw. "Regaining Ownership After Foreclosure: Statutory Redemption." Accessed June 21, 2020.
Since 2009 Tom Lutzenberger has written for various websites, covering topics ranging from finance to automotive history. Lutzenberger works in public finance and policy and consults on a variety of analytical services. His education includes a Bachelor of Arts in English and political science from Saint Mary's College and a Master of Business Administration in finance and marketing from California State University, Sacramento.