Options for Underwater Homes: Foreclosures, Short Sales, and Loan Modifications

FIFODear Leon, 

I have a bloated, interest-only loan on my home. (I purchased my home in home in Los Angeles around February 2007). I am totally ‘upside down’ and I can no longer afford to make the payments. 

For the past few years, I have been juggling my work and flying back and forth to the east coast to care for a family member with Alzheimer’s. Now my reserves are almost wiped out and I am seriously struggling to make my first and second mortgage payments. In spite of rumors that the housing market is on the verge of making a comeback, for me, the odds of that happening are not worth betting on. 

I am completely overwhelmed – trying to do the right thing while maintaining my excellent credit. However, I am at my wits’ end and need guidance. Should I do a short sale, let my home go into foreclosure, try to get a loan modification, or try some other option? 

I have no other debt beside my car, and I managed to pay off my recent credit card debt with my 2012 tax return.

Can you help? 

Thanks, Monica  

Dear Monica,

Caring for a loved one plus mortgage troubles is overwhelming. No wonder you feel at your wits’ end. I would feel the same way.

Here are some of your options.

Loan Modification

I suggest that you first seek a loan modification. The big banks have become much more lenient. You have nothing to lose by trying.

You can get information on the federal Making Home Affordable programs, which include loan modifications, on Nolo’s Government Foreclosure Prevention Programs topic page.  You may also be able to negotiate a modification directly with your lender/servicer.

If you can’t get a worthwhile modification, you may have several other ways to go. But before you quit paying your mortgages, decide what your highest priority is: to dump the house or protect your credit? People rarely can do both, but you can still try.

Short Sale

If you can’t get an acceptable loan modification, you might want to consider a short sale. If you go this route, I suggest you keep both of your mortgage loans current. By doing so, the adverse impact to your credit will be minimal or none.  But before you negotiate a short sale, check with a good CPA to find out if there is a tax bite waiting to get you after the sale.

Unfortunately, your lender may not agree to a short sale unless you are behind on your mortgage payment. In fact, most real estate agents will advise you to stop paying your mortgage to increase your chance of getting the lender’s approval of the short sale. Of course, when you stop making mortgage payments, your credit will take a hit. You’ll have to decide whether short selling is worth the damage to your credit.

Letting Your Home Go Through Foreclosure

If you can’t get a short sale approved and you plan to let your home go through foreclosure, you might be on the hook for the balance remaining on the second mortgage. I would advise meeting with a local bankruptcy specialist right away for basic advice. Bankruptcy can wipe out your liability for any deficiency. In some cases, you won’t be liable for a deficiency anyway, which would mean a bankruptcy wouldn’t be necessary. A good bankruptcy attorney can tell you whether you’ll be on the hook for the second mortgage or not.

Here’s how this all works:

If you stop paying your mortgages, your first mortgage lender will eventually foreclose on your home. If your second mortgage is a home equity loan, the second mortgage lender can sue you for the loan balance. This is where bankruptcy comes in – you may be able to wipe out your liability for the loan balance in bankruptcy.

To learn more about short sales, loan modifications, and other options to avoid foreclosure, visit Nolo’s Alternatives to Foreclosure section.

However, in California, if your second mortgage is a purchase money loan (meaning you got the loan to buy the home), the lender can’t sue you for a deficiency balance. In this scenario, you wouldn’t need to file for bankruptcy after the foreclosure. Of course, either way, you would sacrifice your credit. But, you would probably get to live in your house payment-free for six months or more while the foreclosure proceeds.

Leon Bayer is a Los Angeles bankruptcy attorney.  He is a partner at Bayer, Wishman & Leotta, a California law firm specializing in bankruptcy.  The opinions and advice in this blog post are from Mr. Bayer alone, and should not be attributed to Nolo.  By answering a question on this blog, Mr. Bayer does not become your lawyer. 

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