The Money Class
Page 12
In the meantime, I want anyone considering a modification to be very aware of what they may be walking into. Before you agree to a trial modification I recommend you get the lender to answer—in writing—the following questions:
Do I meet the financial requirements to be eligible for a permanent modification?
When will you decide on making my modification permanent? (It is supposed to be three months, but the average wait time has been four times as long.)
If I am denied a permanent modification, will I owe any balloon payment? If so, how fast must I pay back that balloon payment?
I then want you to stand in the truth. Given the sorry statistics on how many homeowners in trial modifications are turned down for a permanent modification, I want you to ask yourself whether the better move—the one that allows your family to in fact move forward—is to walk away from the house.
TIP: Tax Break for Short Sales and Foreclosures Before January 1, 2013. Before the financial crisis, if you walked away from a mortgage and your lender forgave you the difference between the sale price and the mortgage balance, you still had a potential federal tax bill. The amount of the forgiven amount was reported as “income” given to you and you would owe tax on that income. But a special law passed in 2008—the Mortgage Debt Relief Act—temporarily does away with this tax bill. Through December 31, 2012, any short sale or foreclosure in which the lender forgives any unpaid portion of your mortgage not covered by the sale price is exempt from the tax. The mortgage must have been taken out before January 1, 2009, for a primary residence, and the maximum loan amount covered is $2 million. For those of you who are considering a loan modification, I want you to be aware of the expiration date for this tax break. If you have any doubt whether you will qualify for a permanent modification, or whether even with the modification you will be able to hold on to the home, the wise move may be to let go of the home and have it sold/foreclosed before the end of 2012. If you wait longer and you ultimately need to give up the home, you may not be able to take advantage of this important debt forgiveness regulation.
Short Sale
In a short sale your lender agrees to let you sell your home for a price that is less than the outstanding balance on your mortgage, and the lender will not require you to pay the difference. Lenders know they are likely to get a higher sale price through a short sale than if they have to foreclose on a home and incur all the costs of that process, including selling the house. That’s their incentive for considering a short sale. But a lender will not extend a short sale option to anyone who merely doesn’t want to pay their mortgage. Please respect the truth that your mortgage is a legal obligation; you promised to make a payment. If you no longer want to make the payment that is not nearly a good enough reason for the lender to agree to a short sale. You must exhibit a financial need for the short sale, such as a change in your household income, or an adjustable mortgage that has adjusted to the point of being unaffordable.
If your lender agrees to a short sale it will have the final say on accepting a buyer’s offer. That is, the lender can turn down a buyer’s offer if it decides it is too low, even if that means the lender will then start the foreclosure process on your home.
Deed in Lieu of Foreclosure
In some instances, lenders may be willing to work out a deal for you to hand over ownership of the home to the lender without having to go through the formal foreclosure process. It is entirely up to a lender whether it wants to go this route, and typically this will be offered only if a short sale was not successful.
Foreclosure
This should be your last-resort option if you must walk away from a home and you have been unable to work out a modification, short sale, or deed in lieu of foreclosure with your lender.
In a foreclosure the lender takes back ownership of the home and assumes responsibility for selling the property. In twenty-three states this process must go through the court system; in all other states there is no requirement for judicial review. In early 2011 we are in the midst of the latest twist in the housing fiasco: lenders pushing through foreclosures while cutting corners in documenting the process. As noted above, in the most extreme cases there are now questions as to whether lenders can prove they in fact have title to these properties.
The behavior of the banks and mortgage servicing companies has been awful. That is not to be debated. But I do not want any of you who are in foreclosure because you have not been able to pay your mortgage to think that this is some sort of reprieve and you will be able to win back your home. If you cannot afford your home, you cannot afford your home, regardless of the paperwork mess. That said, you may be able to use the debacle to your advantage; to the extent it slows down the foreclosure process that gives you more time to think through your next step. The healthiest move is to move out as soon as possible, but if you are not paying the mortgage, staying put while the foreclosure process plays out can give you a few more months—maybe even a year or more—to save money so you can secure a rental once you do move out. The fact that you are in foreclosure means your credit score has already taken a hit; so having more money to make a larger security deposit on a rental may be necessary to convince a landlord to rent to you.
Now, I am not blind to the controversy in suggesting that strategy. But if you have in fact done your very best to work out a solution—and despite your good-faith efforts (see the modification problems I just detailed above) you are still tossed into the foreclosure process—I have no problem suggesting you use the time it takes for the bank to formalize the foreclosure to save as much as you can.
Tax Breaks on Foreclosures
As I mentioned above, through 2012 any foreclosures or short sales of a primary residence that result in a home being sold for less than the mortgage balance are eligible for an important tax break: The amount of the shortfall, which typically is treated as taxable income by the IRS, will not be taxed.
But that does not mean you are free and clear of all obligations.
In certain states, under certain circumstances, a lender or a collection agency can seek a “deficiency judgment” that would require you to repay the difference between the mortgage balance at the time of the foreclosure and the market value of the home. Please understand that just because you “walk away” from the home through a foreclosure, you could indeed still be on the hook for at least a portion of the unpaid balance of the loan. And depending on the state, you could be hit with a deficiency judgment four or five years after the foreclosure! What you may be liable for depends on what type of mortgage you have, and your state. If you have what is called a recourse loan, that means the lender, in certain circumstances and in certain states, may have the right (recourse) to sue you for the unpaid portion of the mortgage. If your mortgage is nonrecourse that means the lender doesn’t have the right to seek payment for the unpaid balance.
The best investment you can make at this juncture is to talk to a real estate attorney with foreclosure experience so you can understand what may happen to you after the foreclosure. Please don’t assume that just because you live in one of the nonrecourse states, your loan or the specific nature of your mortgage protects you from a deficiency judgment. (Nonrecourse states that prohibit deficiency for most home mortgages are Alaska, Arizona, California, Minnesota, Montana, North Carolina, North Dakota, Oklahoma, Oregon, and Washington. Please note, other states impose restrictions on lenders’ ability to seek deficiency judgments. As I said, retaining a lawyer well versed in your state’s foreclosure laws is very important.) While nonrecourse means that you are generally protected from any deficiency judgments, you need to know if your actual mortgage is recourse or nonrecourse. And even if it is nonrecourse you could under some circumstances still be liable for a deficiency judgment. For example, only mortgages for a primary residence are generally protected. Any foreclosure on an investment property or HELOC loans is not protected from a deficiency judgment. And in some nonrecourse states, if the lender was granted the foreclo
sure through a judicial proceeding it can then seek a deficiency judgment.
I can’t emphasize enough how important it is to sit down with a real estate attorney who can spell out the rules and regulations in your state. I want you to go into the process with eyes wide open. Sadly, some people who “walked away” are now finding they must declare bankruptcy after the fact to deal with a deficiency judgment they can’t afford.
UNDERWATER BUT YOU CAN AFFORD THE MORTGAGE
For those of you who are underwater on a mortgage but can still afford the payment, your decision involves more than financial issues.
I want to be absolutely clear about what I believe is the right thing to do. If you are 5%, 10%, even 20% underwater, and you can afford the mortgage, I cannot condone walking away. I don’t care if rents are cheaper. That mortgage is a legal document; you do not walk away from it out of convenience. If you want out, then sell the home and use your savings to make up any difference between the sale price and your remaining balance. That is what I call being financially responsible.
I also hope that if you are only marginally underwater, you retain the perspective on what your home is. If your family loves that house, if it is the refuge and centerpiece of your family, and you can afford the mortgage, then don’t get caught up in its current value. We are most likely through the worst of home price losses. Enjoy your home for the shelter it provides today, and over time—it might take ten or more years—you will likely see its value rebound.
Now, that said, I do indeed respect that some of you who bought at the peak of the bubble in the most inflated markets—Florida, Arizona, and Nevada among them—may now be 50% or more underwater. And in those instances I understand the rationale of walking away. For example, I have a dear friend who made a $140,000 down payment on a $700,000 home in Tampa, Florida, in 2007. She certainly met my stand-in-the-truth test of a 20% down payment. But since then, not only has the value of her home sunk to $150,000—that is what identical homes are selling for—but also her association fees have gone through the roof because so many of her neighbors have stopped their payments, or have already foreclosed. And she’s actually lucky; at least her neighborhood remains safe; I know so many of you who are deeply underwater are now surrounded by empty homes. That’s not just spooky, it is easy pickings for burglars. So I get it. My friend ended up walking away and having to declare bankruptcy—she had a recourse loan. There was no triumph in this. But there was relief from an awful situation where no one would work with her to come up with a modification.
The hard truth my friend stood in, and the hard truth some of you must face, is that it could be decades, if ever, until you will see home values return to their pre-crash levels in these hardest-hit areas, especially if your neighborhood and region is currently overwhelmed with foreclosures. In those instances you must dig deep and decide what is the right financial move for you.
HOW LOAN MODIFICATIONS, FORECLOSURES, SHORT SALES, AND DEEDS IN LIEU OF FORECLOSURE AFFECT YOUR ABILITY TO GET A MORTGAGE IN THE FUTURE
When you do not fulfill your obligation to repay your original mortgage in full—even if the lender has agreed to a workout—your credit report will note the underpayment. According to FICO, the leading resource for credit scores derived from your credit report, a loan modification, short sale, deed in lieu of foreclosure, and foreclosure are all treated the same in terms of your credit score. One is no better, or worse, than the other. Once the underpayment shows up on your credit report it will remain there for seven years. How much it will hurt your score varies; if you had a high score before, it will have a larger impact; if your score was already low, it will have a smaller impact. The impact of this demerit declines over time; it will have less impact six months from now than it does today, and its impact three years from now will be less than two years from now. If you focus on the steps that help your credit profile—on-time payments, for example, and keeping your debt level low relative to your available credit—you can in fact repair a lot of the damage in less than seven years.
While FICO does not differentiate between the various types of loan workouts, mortgage lenders do. I know this might sound a bit crazy when we are talking about walking away from your house, but it is important to understand how your ability to buy another house in the future will be impacted by how you walk away from your current home.
As I write this in early 2011, the vast majority of lenders follow the rules laid down by Fannie Mae and Freddie Mac. These two agencies either guarantee or buy up most of the mortgages that lenders make; thus lenders are careful to make sure they follow the guidelines for what qualifies to be bought or guaranteed by either government agency.
If you go through a formal foreclosure, you may need to wait five years to qualify for a new mortgage that is backed by Fannie Mae. The wait can be less if you can document that the foreclosure was due to an “extenuating circumstance,” such as a divorce or losing a job. But if you walk away through a short sale or deed in lieu of foreclosure, you may be eligible for a Fannie Mae–backed mortgage in just two years if you have a 20% down payment, or four years for a 10% down payment. This rule presumes you are able to meet all other credit and income qualifications for the mortgage.
LESSON 5. HOW TO REDUCE MORTGAGE COSTS
Despite all the headlines this rash of foreclosures is getting, the truth is that the vast majority of homeowners can in fact afford to stay in their homes—and want to stay in their homes. But those of you who are in this category have a new dream to consider as well. Whereas borrowing as much as possible to buy the biggest home possible was a centerpiece of the old American Dream, for many of you, your new home dream is to get your mortgage paid off as quickly as possible, or to take advantage of the current low mortgage rates and refinance into a less costly loan.
WHEN IT MAKES SENSE TO PAY OFF A LOAN AHEAD OF SCHEDULE
As I explain in great depth in the class about planning for retirement in your 40s and 50s, I think one of the best retirement strategies to put in place is to have your mortgage paid off before you retire. So for anyone who is at least 50 years old and is absolutely sure they will stay in their home through retirement, I am all for accelerating your loan payments so you get the mortgage paid off. If you want to learn more about my reasoning and my recommendations for how to accomplish this, please see this page–this page.
THE NEW REALITIES OF REFINANCING
For those of you eager to reduce your mortgage costs, today’s record low mortgage rates offer an incredible deal. As of early 2011, the 30-year fixed-rate mortgage has an average interest rate below 5%; creditworthy borrowers may be able to grab a rate as low as 4.8%. And a 15-year mortgage has a 4.1% rate.
But to be able to refinance you will likely need to have at least 20% equity in your home. If you don’t have that much equity, you will need to bring cash to the deal to reduce your loan amount to the magic 20% level. This is what is known as a cash-in refinance, and in 2010 it accounted for about one-quarter of all refinancings.
I think a cash-in that helps you lock in a lower rate can make tremendous sense if you have the savings to bring to the closing. I do not want you tapping your emergency savings fund for this, nor are you to touch your retirement savings. If you want to do a cash-in, you must have extra savings you can use to pay down your loan to the 80% level.
Whether you are doing a straight refinance or a cash-in refinance, please heed the following.
REFINANCING RULES
Never Extend Your Loan Term
If you have 20 years left on a 30-year mortgage, you are never to take out a new 30-year loan. That will extend your total loan term to 40 years. The goal should always be to maintain or reduce your total loan term when you add the time you have already paid on your current mortgage to the length of the new mortgage. So if you are 10 years into a 30-year mortgage, your refinanced mortgage should be for no more than 20 years. In fact, as I explained earlier, I would root you on if you could handle refinancing into a 15-year mor
tgage. The whole point is to get the mortgage paid off sooner rather than later.
Calculate the Cost of the Refinancing
There are fees to pay when you refinance. Those can be 1% to 2% or more of the loan amount. Ideally you will pay the fees in cash up front. But if you can’t swing that right now, then go ahead and roll the refinancing fees into the new mortgage; yes, your monthly costs will be slightly higher, but if this move does indeed ensure you can get the home paid off faster, and ahead of your retirement, then that’s the big-picture goal we need to focus on here. However, you need to understand how long it will take for the lower cost of the new mortgage to offset the fees you paid for the refinance. At Bankrate.com you can use a calculator to compute how many months it will take you to recoup your costs. If you anticipate you might move before then, think twice about the refinance.
Consider a 15-Year Mortgage
The interest rate on a 15-year fixed-rate loan is typically about 0.5% less than the rate on a 30-year. In early 2011 the spread was even greater, about 0.7%. If you are refinancing a mortgage with 20 or more years left, run the numbers to see if you can afford to go with a 15-year mortgage. The 15-year will always have a higher monthly payment than a longer-term loan, but you will spend thousands less in interest payments, and you also have the satisfaction and security of getting the loan paid off sooner rather than later. But don’t overstretch to make a 15-year work. This only makes sense if you have the available cash each month to easily handle the payments. And you must still continue to contribute to your retirement savings. If you are in your 30s and 40s I don’t think paying off your mortgage should be your highest priority just yet; focus on retirement savings, your emergency fund, and if you want, putting away some money for the kids’ college education.