I counsel a lot of clients and potential clients who have fallen behind on a mortgage. Some of these are homeowners and many of them are investors who have fallen on hard times with rental properties.
There are a number of misconceptions about the consequences of a foreclosure. In Minnesota, because we have a non-judicial method of foreclosure called “foreclosure by advertisement” where the lender is prohibited from pursuing a deficiency judgment against a borrower following a foreclosure sale, many people think that they’ll just walk away from the property (and, in the case of the now-trendy “strategic default”, stop paying the mortgage) and be through with the problem. However, it’s not that easy.
One of the most common conversations I have with people in foreclosure or headed to foreclosure regards what happens with the junior mortgages. If there is a second mortgage on a property that is foreclosed upon, and even though the second mortgage holder has the right to redeem the property from the foreclosure sale, that does not mean that the property owner walks away scot-free. It is important to remember that a mortgage is simply a security interest for a debt, and it is the promissory note that evidences the debt. A smart second mortgage holder will forego redemption of an otherwise-underwater property and instead commence a collection action against the property owner – who also happens to be the borrower on the promissory note – for a money judgment in the amount of the balance owed. Once obtained, the borrower has two ways to get rid of the judgment: either pay it off or file bankruptcy and have it discharged. Hence, if a property owner becomes a judgment debtor, they have now subjected their personal assets (wages, etc.) to the reach of the second mortgage holder.
The other cost of walking from a property is, of course, the damage inflicted to one’s credit, often evidenced by the period of time in which an individual must wait before obtaining a mortgage on a new property.
While these standards are ever-changing and vary from lender to lender, my good friend, Mike Ouverson , mortgage consultant at Waterstone Mortgage, recently shared with me Waterstone’s guidelines, which are as follows: for conventional loans, if a borrower went through a short sale, that borrower must wait must wait 2 years if they have 20% to put down and re-established credit since the short sale, 4 years if they have 10% to put down and re-established credit since the short sale, and 7 years if they want max financing per conventional loan guidelines (5% to put down)
If the borrower went through a foreclosure, that borrower must wait 3 years if there was an extenuating circumstance and they have 10% to put down (an extenuating circumstance would be death of the primary wage earner or medical event causing financial hardship) and 7 years if no extenuating circumstance exists.
For FHA loans, if a borrower went through a short sale, that borrower must wait 3 years to buy a new property unless there was an extenuating circumstance (death of the primary wage earner of the family, medical event causing a financial hardship… divorce is NOT an extenuating circumstance). If that borrower went through foreclosure, they must wait 4 years to buy a new property unless there was an extenuating circumstance.
Long story short: owning a property that is underwater and the mortgage is in default requires careful consultation with appropriate professionals – especially an attorney – about all of the possible consequences which may arise and how best to mitigate these consequences. To proceed in any other manner would be imprudent.