Picking Poison – Distressed Housing Choices

Choosing between unpleasant alternatives isn’t fun.  Like getting hit by a train or a bus.  They’ll both hurt.  But this is the task many distressed homeowners face today.

For those homeowners truly “underwater”, the choices are all bad. And the government’s loan modification program has a batting average that that wouldn’t get them into the minor leagues.  Besides that, the modification process can go on for months, only to result in the lender refusing to play ball.

Besides loan modification, which tears the Band-Aid off as slowly and painfully as possible, what are the remaining alternatives? Conventional wisdom – if there is such a thing today – places them in the following order, from “least bad” to “most bad”: Short Sale; Deed-in-Lieu; Foreclosure; Bankruptcy.

Reserving the last option for the bankruptcy attorneys to debate, I believe conventional wisdom may have the order reversed – at least in Oregon.  Assume that your only credit blemish is one or two ill-advised loans – which actually puts you in pretty respectable company.  Surprisingly, the foreclosure option is worth considering.  It is true that foreclosure will likely have the greatest impact on your credit – perhaps five or more years, depending upon your overall credit picture.  But with the huge number of foreclosures over the last few years, I suspect the credit bar is slowly starting to lower.  Fannie Mae, the secondary mortgage market giant, has already signaled this.

Why would foreclosure be a first choice rather than a last choice?   Setting aside the inevitable “moral hazard” discussion  – which I will address in another post – foreclosure has many features in Oregon that make it an option deserving serious consideration.  At least it should not be completely ignored.

Here’s a list of reasons for Oregonians, with no particular order of preference:

  • Foreclosure may cut off lender claims for promissory note liability on the first mortgage, if the home is a primary residence.
  • Foreclosure may also cut off lender claims for promissory note liability on the second mortgage, if the home is a primary residence and the second mortgage was taken out at the same time as the first and obtained from the same lender, or an “affiliate”.
  • Once you stop making payments to the bank, the next move is up to the bank…and this can take half a year or more just to get on their radar screen.  In almost all cases of loan modification, and even in some short sales and deeds-in-lieu of foreclosure, some lenders actually require their borrower to default before dealing with them.  So, by the time the foreclosure is actually commenced, another four to five or more months will elapse.

Conversely, the other alternatives for distressed homeowners all have the same disadvantages:

  • There is no assurance (nor requirement) that the lender will consent to the loan modification, short sale or deed-in-lieu.  Several months or a year can elapse.
  • There is no assurance (nor requirement) that the lender will agree to waive all claims for promissory note liability. You don’t know for sure until the 11th hour.
  • In most cases, especially loan modifications, lenders still require some continuous monthly payment as a show of good faith.  In others, the proposed modification still exceeds the borrower’s monthly payments, frequently because taxes and insurance are added into the payments and/or the penalties and late fees are added onto the principal balance.
  • By the time you learn whether the bank  will cooperate, months of uncertainty have passed.  While the problem is most prevalent in loan modifications, it can also occur in short sale and deed-in-lieu approvals.

Foreclosure is not a choice for everyone. People are free to disagree with my analysis.  But before dismissing it as an alternative, you may want to discuss it with your attorney.  According to Realtor Magazine, the average homeowner in foreclosure is unlikely to be evicted for 438 days.  This according to LPS Applied Analytics.  What is “average” nationally may not be “average” for Oregon.

I have intentionally ignored any income tax analysis, in deference to the CPAs and tax attorneys.  But I suspect that in most cases involving underwater first and second home purchase loans, the tax impact due to cancellation of debt (“COD”) income will be limited if the borrowed funds were used to build, buy, or materially improve a primary residence.  However, under no circumstances should anyone make an important decision about their distressed housing options without first obtaining competent professional review of their specific financial situation – on all three fronts; tax, credit, and promissory note liability.