Home owners who are “underwater” with their home loan and seek to come up for air by walking away from the debt, could still be gasping for relief years down the road.
There are occasions when walking away from your home — and down the road to foreclosure — is your only alternative, but seldom is it the best alternative.
Mortgages are “underwater” or “upside down” when the property experiences negative equity — the mortgage is larger than the current value of the property. Negative equity is caused by a decline property value, an increase in mortgage debt or, most likely, both.
First American Core Logic says nationwide more than 11.3 million home owners are underwater with their mortgages.
That’s due both to the rapid decline in over-inflated property values during the housing bust, as well as home owners’ housing boom habit of tapping their home equity like it was an ATM machine.
Nearly 40 percent of mortgaged home owners in California are underwater or about to submerge, according to First American’s 4th Quarter 2009 Negative Equity Data Report
Among all California’s mortgaged home owners, 20 percent have negative equity of 25 percent or more, that is, if the home is valued at $500,000 the mortgage is $625,000 or more.
How deep?
“Most likely they got one of those low rate, adjustable, negative amortization, little- or no-money-down loans and bought their home for $600,000,” said Rob Roham broker owner of Advisors Real Estate Group in San Jose.
“They probably have a loan of over $500,000 on this property. The value of this home has dropped to under $300,000. Even if the home owner has a good job or business and can afford to pay the monthly mortgage — which by the way, will continue to go up — why should they make payments for the next 20 plus years, on a $500,000 loan when the property is worth only $300,000,” asks Roham.
Roham continues, “They worked hard to buy a piece of the ‘American Dream’ a few years ago, with hopes for a nice home to live in and plenty of real estate equity to hopefully retire with some day.
“Now, the market has crashed and not only they have not made any equity but they have lost what they put in as down payment and are about to lose the home they live in also. Times like this, walking away from the home, maybe the best option,” Roham said.
Moral obligation
No one can predict how long it will take for appreciation and property values to return to levels sufficient to eliminate walking away as an option, but experts say equity gains should never be the sole basis for buying a home in the first place.
In good times and bad, buying a home comes with as many as a dozen tax write offs from the interest on the first and second and mortgage and points to a home-based business deduction and a capital gains tax exclusion when you sell.
Unlike rental living, owning a home is a tangible asset, an investment that’s also a roof over your head with the potential for rent-free, income-producing space.
Some argue, in exchange for the shot at all those hefty perks, courtesy the American Dream, home owners have an obligation to prudently plan to buy only what they can truly afford, invest wisely with a down payment sufficient to create an upfront equity cushion, and to meticulously manage the mortgage so that equity remains in place for emergencies or other sound investments with a decent return.
Even home owners who do all the right things and still get burned, they are nevertheless obligated by contract to pay up — or so the argument goes.
“In addition to the hefty moral issues, there will be hidden punishments that attach themselves to people — a lower credit score the hidden penalty of higher insurance premiums and perhaps, one’s hire-ability for certain jobs that require a security screening,” said Mary Pope Handy, a real estate agent with the Sereno Group in Los Gatos.
Foreclosures constitute a loan default and that can crash a credit report and credit score for up to seven years.
Also, there is a potential that certain jobs tied to checking a consumer’s credit report (say, for security clearance) will become elusive. Financial services like insurance can become more expensive. Most credit, especially cheap credit will disappear for the duration of the black mark.
Perhaps only a few years will pass before creditors return with new offers, even if your credit report is still scarred by the foreclosure. However, your credit score will remain low and you’ll pay through the nose for any credit you can get.
“Heck, you can buy a home after a bankruptcy after two to three years. If you walk away in a foreclosure, it will be about three years before you can buy again,” says Robert Aldana, a real estate agent with Intero Real Estate Services in San Jose.
“Too many people get caught up in the moral dilemma. You need to look out for your family and what best for you and them. Lenders do the same and will take your home if it makes sense to them regardless of how many kids you have,” Aldana said.
Aldana has another perspective.
“If you owe $600,000 on a property that is worth $300,000, with an average appreciation rate of 3 percent per year, it would take you 13.25 years just to recoup the loss and break even. That means that for the next 13.25 years, you are paying rent on your home because you are not making any money, you are barely breaking even. And probably not paying a cheap rent either,” Aldana says.
Aldana adds, “If the lender gave you a loan mod with a 3.5 percent fixed rate payment for that loan of $600,000, your payment would be approximately $2,694. Add taxes and insurance and your total payment is somewhere around $3,500 which is about $1,500 more than what you would be paying for rent on a similar home. That’s an extra $90,000 in 5 years or $180,000 in 10 years of extra payment versus rent. And that’s supposed to be OK as long as you get to say that you are a homeowner?”
Tax implications
In addition to consulting with a financial expert about the credit report and credit score implications, a tax expert’s advice also may be necessary to understand potential tax implications on both the state and federal levels.
When a lender forecloses on a home and accepts a sale amount less than the loan balance from sale of the home, that can result in a gain (forgiven debt or canceled debt) that is potentially taxable income for the homeowner.
California’s Franchise Tax Board says original acquisition mortgages that go into default are considered “non-recourse” debts, those for which the lender has no other recourse than the collateral property from which to recover the loan amount. In a foreclosure on non-recourses debts, gain is excluded from taxes, but that may not be the case if the original mortgage is no longer in place, say because of a refinance or other adjustment.
Under federal law, “The Mortgage Forgiveness Debt Relief Act of 2007″ generally provides the same exclusion, including any debt reduced through mortgage restructuring, say a mortgage modification. The exclusion from taxes, however, is only for mortgage debt forgiven from 2007 through 2012.
Homeowners considering walking away from their mortgage may also want to consider a real estate attorney for any legal implications or wrangling with the lender during foreclosure.
“Anyone who walks away with a foreclosure on their record will have bigger consequences than having a group of professionals help them get out of it with minimal damage not only to their credit, but to the current and future employment, security clearance and any rights for the deficiency judgments,” said George Saghafian a distressed property expert and real estate agent with Intero Real Estate in San Jose.
Alternatives to walking away
The consensus among experts is to consider the alternatives before abandoning your home. Talk with your lender, seek counseling from a U.S. Department of Housing and Urban Affairs (HUD) certified counselor.
“Almost everyone is touched by this economic hard times and home owners need to consult a certified, trustworthy and experience professional to show them all the better options available to them, and at the end the choice still will be theirs to make,” said Rob Roham broker owner of Advisors Real Estate Group in San Jose.
The Obama Administration’s frequently updated and strengthened multi-tiered MakingHomeAffordable.com program and other government efforts offer a good start with a host of options.
• Refinancing, turning in your existing mortgage for a new one, is perhaps the toughest option to accomplish. A refinance requires meeting stiff underwriting requirements — an excellent credit report, a high credit score of 720 or more, documented career level income and little debt, for starters.
Federal programs including the Federal Housing Administration’s refinance effort can be a good bet for those who haven’t yet faced hardship and can qualify for a new loan.
• A mortgage modification reworks the terms of existing loans to get the payment down to a more affordable level. To add greater affordability lenders lower the interest rate, lengthen the term of the loan or reduce the principal — or do some combination of all three. Modifications can be used by qualified home owners who aren’t yet struggling as well as those who are in a pinch.
• Short sales can be particularly useful for home owners struggling with underwater mortgages. The bank allows the sale of a home for less than the existing mortgage balance, typically provided there’s a qualified buyer in the wings. A similar deed-in-lieu-of-foreclosure allows the home owner to simply hand over the property to the bank without a foreclosure. In some cases sellers get up to $3,000 to help defray moving costs.
Modifications and short sales can impact your credit, but not necessarily with the force of a foreclosure.
• Sell. A good real estate agent experienced in tough market cycles can garner the best price. Some sellers might have to come up with the difference between the mortgage and selling price to make good on a home they no longer own. Others, especially long-term owners, could break even or come out of it with a tidy profit.
Bottom line, exploring all the options is a better first step than walking away.
“It is a very personal choice. I understand feeling financial pressure is difficult and embarrassing, but there is a point at which everyone has time to explore the options. In just about every case, that’s much better than doing nothing at all. I strongly feel there is no reason for anyone to get a foreclosure” said Zdenka Mahan, a real estate agent with Intero Real Estate in Los Gatos.
