When Mortgage Debt Exceeds Your Home Value: Avoiding Default or Foreclosure

Man at desk calculating mortgage debt

Your debt exceeds your home value, and you’re unsure of where to find relief. You certainly don’t want to default or foreclose on the home, but is there another way out? There might be if you’re willing to consider a short payoff or short sale.

What is a short payoff?

If you are short or behind on your payments, but could potentially continuing making payments — a short payoff may be for you. A short payoff allows you to sell your home for less than you owe the bank. But first, you must agree to payment arrangements upfront or through a repayment plan.

Criteria for short payoff approval include:

  • Good credit / good financial standing

  • Be current on mortgage payments

  • Have steady income

  • Home value has significantly dropped/your home is underwater

What is a short sale?

With a short sale, the lender will forgive some of the mortgage balance, still allowing you to sell your home for less than you owe. It is an alternative to foreclosure and may be an option if:

  • You are denied the ability to refinance and have no assets that can satisfy the debt

  • You owe more than your home is worth

  • You’ve experienced financial hardship

  • You are in default or about to go into default

What lender would write off that type of money?

Just about all of them will, with justification. Justification might mean a substantial loss of income that would prevent you from paying on the mortgage, therefore being forced into a position to sell the home. In addition, a lack of cash reserves will also serve as justification. Though, attempting to sell short so you can upgrade to a larger property is not justification. Don't expect to place your home on the market at 75% of market value and expect your lender to jump on any offers.

How will this affect my credit?

Depending on how you negotiate the transaction, it could go on your credit report as "settled," "paid," or "short payoff." It depends on the lender and how well you can negotiate. And, since the lender eventually gets most or all of what was owed, a short payoff option should not harm your credit rating.

What will my lender require from me to consider participating in a short sale?

  • Your past two years of tax returns

  • Letter of hardship

  • Complete loan application

  • Preliminary title report

  • Listing contract

  • Copy of MLS

  • A marketing plan for your home

  • A broker price opinion (like an appraisal)

When you have an offer, all of the above should be enclosed with the proposal (except for the marketing plan), plus the purchase agreement, and a good faith estimate as to what the lender will net after the close of escrow.

Can any real estate agent or attorney handle a short sale?

A lot will say they can. But, there's no real way to tell if they can. If your home goes into foreclosure, you'll get flooded with a ton of mail. There's a good bet that most of the mail is from people who have helped out previously in these situations. One way to tell the good from the bad — an experienced agent will ask you for the information outlined above. They'll know that these are the requirements.

How can I assure a non-purchase money lender won't go after me after the short sale?

When any lender agrees to a short pay, they are relinquishing their right to pursue the borrower in the future.

Are there any tax ramifications?

If you choose the short sale approach, the Internal Revenue Service (IRS) treats it just like a sale. It can be considered income, and they may demand you pay taxes on that amount.

So why would I want to do a short sale only to owe the IRS money?

To limit your tax liability. In some cases (not Citicorp, Fannie Mae, or Freddie Mac) the senior lienholder will allow for some funds to be allocated to the juniors. If you allow the property to go into foreclosure, and the juniors lose 100% of their money, you can get taxed on the full amount. You should contact a CPA concerning this part of the Tax Code.

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