Why You Should Not Walk Away From Upside-Down Real Estate

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I keep reading stuff on the internet advising people who are upside down to just walk away if they are a upside down on their mortgage. This has got to be right up there with the worst financial advice I have ever heard.

Here's the thinking: You owe more than the property is worth, and the loan is non-recourse. So the thinking goes that if you just stop making payments and walk away from the property, you're essentially paying yourself the difference.

Not so.

First off, debt forgiveness is taxable income. You borrow $500,000 for a home, that's exactly the same as the lender handing you $500,000. If they only get $400,000 back when the home sells, that's $100,000 of taxable income to you. While it is true that there is currently a temporary amendment to the tax code still on the books at this point in time, it is set to expire at the end of 2008. It is possible that Congress will act to extend or reinstate it, but my guess is that they will not, and if they do, there will be enough exceptions to make it useless for 95% of the people. The lenders really don't like this as it encourages people to lose them money, and contrary to campaign propaganda, it isn't the Republicans who have been dancing to the tune of the lender's lobby. Furthermore, it's already too late to start this process going, as it is the effective date of the final dispository sale which controls the rules in effect. You start right this instant as I'm writing this, and you're looking at something in late February of 2009 if you're exceedingly lucky. Even if you had given the lender a deed in lieu of foreclosure back in June, it still would have been iffy, and most folks force the lender to go through the whole foreclosure process.

Second, your credit is going to take a hit that is going to last up to ten years. Not seven, not two. From Form 1003, the federally required loan application. Every single real estate loan through a regulated lender must use this form. Some of the "Thirteen Deadly Questions" on page four of the form:

a. Are there any outstanding judgments against you?

b. Have you been declared bankrupt within the past 7 years?

c. Have you had property foreclosed upon, or given title or given deed in lieu thereof within the last seven years?

...

e. Have you been obligated on any loan resulted in foreclosure, transfer of title in lieu of foreclosure, or judgment?
f. Are you presently delinquent or in default on any federal debt or any other loan, mortgage, financial obligation bond or loan guarantee?

Look at question e again. There is no time limit. You will be answering that question "Yes" for the rest of your life. If you want your loan approved, even forty years from now, I strongly suggest you have done everything you possibly could to make good on the debt. Judgments typically last ten years, as does the notation, "Settled account." You are going to have a period of two years where lenders can't touch you, even if they want to, it can be ten years before they're willing to take a chance, and you're going to be sweating the fall-out to question e for the rest of your life, because that is cause for extra underwriter scrutiny, and a lender being unwilling to approve even minor variations forever.

Now here's something lots of folks aren't considering: It's true that purchase money loans are non-recourse in California and many other states. That's a good thing, as far as it goes. But there are limitations upon that. One of the limitations is fraud. here's the legal definition of fraud:

All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprises, tricks, cunning or dissembling, and any unfair way which another is cheated.

Did you "shade the truth" on your loan application? Lots of folks did. Right now, this is a big problem, and one reason why I have always hated stated income loans. Just because the lender doesn't hit it today when the property sells, doesn't mean it goes away. The lender has a minimum of three years to file a suit. They may file a suit even on comparatively small amounts of several tens of thousands of dollars, hoping that you don't show up in court. If you don't show up, the default judgment is entered against you, and that is very hard to overturn. If you lied on your loan application, that turns even a non-recourse loan into a recourse loan. They can go after savings, retirement assets, pension plans, attach your paycheck, you name it. Even if they don't want the rigamarole themselves, they can sell the rights to collect, or even put them out to law firms looking for a bounty on whatever they can get out of you.

Furthermore, if there's some reason to do so, they can pass the paperwork on for criminal investigation. Fraud carries criminal penalties, and it's the government footing all the bills of pressing the case.

Now here is another reason why you shouldn't walk away: If you do so, you are taking all of these consequences and bringing them into the here and now of concrete consequence of actions that have already been taken. But the real estate market is cyclical. Just keep making your payments, and it will come back (it's already starting to rise again here in San Diego, and we're still hip deep in short sales and foreclosures). Maybe there are some exceptions to this, but I'm not aware of any.

Let's look at a personal experience I had with my first property. Bought for $90,000 in 1990, value peaked at $106,000 the next year, then crashed to $63,000. I didn't buy "zero down" like probably the majority in the recent price runup, but the principle is the same. Some people thought they should walk away. Having lived through four previous cycles locally, I just kept on keeping on with the payments. By 1996, the property was worth more than I paid again, and not too long after, people who had just kept on keeping on with their payments were in a position to sell for a huge profit.

Had I sold while the property market was down in the nineties, I would have suffered most if not all of these consequences. By just making the payments, I effectively let time fix the market for me.

By making those payments, all you're doing is sitting on a temporary loss on paper, as opposed to turning it into a hard loss with real world consequences. The paper loss has precisely zero importance - unless you sell while the market is down. The only times the value of the property is important is when you refinance, and when you sell. It doesn't matter what the value is at other times - unless you make it matter by choosing to sell. If you've got a sustainable loan, keep making the payments, and in two years or five, you'll be in a position for make money again when you sell. What's hurting the real estate markets badly is excess supply and low demand, caused by people who have no choice but to sell, and fewer buyers than usual. What happens when these conditions go back to a more normal market? That's right, the prices go back right where they were - if not higher.

Furthermore, if you get out by selling short or through foreclosure, it's not like you're going to be able to jump back into something else any time soon. Absolute minimum two years, as above, and perhaps much longer than that. You jump out of an upside-down mortgage, and you're going to be sitting out the absolute sweetest time to be in the market - right when it starts to recover. You sell or allow foreclosure, and you turn that theoretical paper loss of $100,000 into a real concrete loss of $100,000. That's permanent, and you're out of the market until lenders are willing to take another chance on you, which could be never. But, if you stay in the property, when it starts gaining value again, you're still in the market. I know lots of people that turned $30,000, $50,000, $100,000 or more of temporary paper losses into profits several times the size, simply by holding on and allowing the market time to recover. Profit or loss on an investment is measured solely by price at acquisition versus price at disposition. If you buy for $500,000 and sell for $300,000, it makes precisely zero difference that it was worth $700,000 at some point in the middle. Similarly, if you buy for $300,000 and sell for $500,000, the fact that the property was worthless at some point between is irrelevant to the fact that you still made a $200,000 profit.

If you have an unsustainable loan, there are options to deal with the problem. Refinance if you can. If you can't, call your lender and see what you can work out, or try a loan modification. For their part, lenders are trying to keep the problem from getting worse than it has to be, and every time someone takes a loss because they couldn't hang on, the lenders take the exact same loss if not worse. There are limits to what they are willing to do, but I am amazed at some of the deals they really have accepted because they believe it is better than what will happen if they don't. Which situation would you rather be in: able to hold on and eagerly awaiting the market comeback that's going to happen, and will benefit those than hang on, or stuck with a bad situation permanently because you couldn't stand the thought of being upside-down on paper?

Caveat Emptor

Article UPDATED here

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2 Comments

stevevoita@yahoo.com said:

You forgot that someone can still buy a home with bad credit by buying on an owner carryback. You could have a hundred foreclosures on you're credit, but if you find and owner willing to carry you're right back in business. And there are tons ready to carry. Class dismissed.

Dan Melson Author Profile Page said:

Didn't forget anything. Owner carrybacks are expensive for buyers - and for a high percentage carryback like this be prepared to pay at least ten percent over market value in up front price as well as a higher rate of interest which you are going to be stuck with. My local market has been in recovery mode for a while now - owners can choose between offers and they're choosing the offer that nets them cash. If you want them to choose otherwise, you have to give them monetary consideration for doing so. Since you're an obvious credit risk, expect the owners to charge higher rates of interest to take a chance on you. And since you can't refinance into a regular loan, you're going to be paying the higher rate for a good long while. Total premium: at least 25% and likely more.

I rate your class a dismal failure leading students into financial malpractice

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This page contains a single entry by Dan Melson published on October 21, 2008 7:00 AM.

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