Walking away from your mortgage has consequences

Thursday, March 25th, 2010

Christine Dugas
USA Today

By Web Bryant, USA TODAY

More homeowners are walking away from their mortgages, even if they can keep up the payments. Falling into foreclosure — voluntarily or not — has become less taboo for many people as they have watched their house values tumble far below the amount they owe, putting them “underwater.”

Purposely defaulting on a mortgage, often called “strategic default,” may be a very rational personal finance decision, but it’s not without major consequences. And it’s not necessarily the best option for anyone underwater who can afford to make monthly mortgage payments but who does not want to wait up to 10 years for the housing market to turn around.

Many factors must be considered, including a key one: which state you live in.

Shelby and Scott Robinson, from Manteca, Calif., married in 2006 and purchased a starter home about a year later for $310,000. It plummeted in value.

They realized they would have to stay in the home for far longer than expected to gain any value back. The area also did not hold much job flexibility for Scott, a restaurant chef. The couple spoke with financial advisers and considered a strategic default.

“It’s not about not having money,” says Shelby, a purchasing manager for a shoe company. “It’s about not throwing money away.”

In the end, they opted for a short sale, an agreement with a lender to sell the house for less than what is owed. They chose that route because it’s not as harsh on their credit score as foreclosure. They quickly found a buyer and are awaiting bank approval for the sale. The buyer would pay $103,000 if the sale is approved.

The deficiency judgment

If you go through a strategic default, your lender may file a lawsuit against you, called a “deficiency judgment,” to recoup losses. The lender can demand payment for the unpaid balance: the difference between what you owe, including the foreclosure cost, and the fair market value of the home.

Lenders don’t always bother to go after people who have been forced into foreclosure. But in some states, such as Florida, they have five years to do so.

“I’ve been hearing that lenders are becoming more aggressive about going after deficiencies in homes that they had to take back,” says Gerri Detweiler, co-author of Debt Collection Answers. “Then you can essentially be paying for a home that you no longer have.”

Some homeowners decide to file for bankruptcy after they go through foreclosure because that can wipe out a deficiency.

But that may not be necessary, because some states have non-deficiency laws that prevent such lender action.

“That means that the lender only can take back the home and cannot sue the borrower for the deficiency,” says Jon Maddux, CEO of YouWalkAway.com. For a fee, his company helps guide people through foreclosure. Among the non-recourse states are California and Arizona.

But even in those states, lenders can still go after you for a second mortgage. And if you had refinanced the original mortgage, the lender may also be able to file a deficiency judgment against you.

Credit scores

Even if a homeowner can avoid a deficiency judgment, a strategic default will cause other problems — chief among them a drag on credit scores.

“I always dissuade people to avoid a strategic default,” says Larry Tolchinsky, a Florida real estate attorney. “I tell them that it’s going to ruin their credit. That’s an asset that I want to maintain and protect.”

The stain on your credit score will eventually go away, although it can last for seven years. But if consumers continue to pay other bills on time, the foreclosure may not have a significant negative impact.

Credit scores affect everything from credit cards to cards’ interest rates to the ability to get new credit to getting a new job.

Normally, foreclosure results in taxable income. But the Mortgage Forgiveness Debt Relief Act of 2007 has been extended to 2012. Under this act, taxpayers may exclude debt forgiven if the balance of their loan was $2 million or less. The limit is $1 million for a married person filing a separate return.

To qualify, the debt must be for your primary home, and the mortgage must have been used to buy, build or improve it. But there may be other tax exclusions for second homes and rental properties.

Don’t forget about state taxes

Homeowners may be hit by a state tax jolt. California, for example, mirrored the federal tax relief for homeowners, but that expired in 2008 and hasn’t been renewed.

Homeowners who are considering a strategic default or a short sale need to talk to a CPA or attorney, because there could be land mines and problems they don’t anticipate, says Brad Nemeth, a tax attorney in San Diego. Experts also say not to rush into a strategic default without exhausting all other options, such as renegotiating your mortgage. One government option is the Home Affordable Modification Program. Details are available at makinghomeaffordable.gov. Homeowners also should talk with their lenders about such options.

When Cheryl Trella, a human resources manager in Chandler, Ariz., ran into distress, she sought advice. Her home had dropped in value, so she hired a lawyer. After talking with her lender about a loan modification, she decided on a strategic default. She suggests others find an advocate and not make these decisions alone.

Experts say all options other than default should be considered, because a home can represent far more than the big financial transaction it took to get it, and to keep it.

“If they have put their own hard-earned money into a house, it makes it much more difficult to walk away,” Maddux says.

“Families should consider how much is it worth to have a place to live in,” says Frank Alexander, professor at Emory University School of Law. “To have a neighborhood where you’re comfortable? To have schools where you have been raising your kids? There are significant transaction costs involved in relocating a family.”

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