The Money Class (14 page)

If you are underwater and can still afford your home, the math and the ethical questions require a different strategy.

IF YOU ARE UNDERWATER AND CANNOT AFFORD YOUR MORTGAGE

I need to start this lesson by telling you what I absolutely do not want you to do, ever: You are never to touch your retirement savings to keep up with a mortgage you can no longer afford. You must respect your retirement truth as much as your housing dream: You will need to have savings to support yourself in retirement. Using that money today to cover your housing costs raises the risk you will permanently doom your retirement dream.

I know this is such a painful truth to face, but it is the right truth. Please try to step back for a moment and think through the outcome of using retirement funds to cover a mortgage payment: All money withdrawn from a traditional 401(k) or IRA will be taxable, and there may be a 10% early withdrawal penalty as well. That reduces what you will have to put toward your housing costs. And whether the tapped funds are taxed or not, the more important issue is that they are being used at all. What’s most upsetting for me is when families withdraw money from their retirement funds to cover a mortgage, and then when those savings are used up they still can’t afford the mortgage. They depleted their retirement savings to do nothing more than delay the inevitable: They can’t afford that mortgage, period.

And as I explain on
this page
in the retirement chapter, I do not recommend you ever take out a 401(k) loan. So please read that advice before you make this costly mistake.

That brings us to the right strategies to pursue if you have a mortgage you can no longer afford. I am not going to sugarcoat anything here. The very sad truth is that banks have, on the whole, been incredibly unresponsive in working with homeowners who cannot afford their mortgages. The help that was promised, I’m sorry to say, did not materialize for so many of you. The federal government’s programs have proven to be woefully ineffective, in large part because lenders are asked—asked, but not mandated—to participate. So far, banks haven’t shown much enthusiasm for helping. I mention all of this to make sure you understand the resolve and tenacity that is required to try to negotiate a deal with a lender.

There are four basic options for dealing with your predicament; I list them here in order of their appeal for distressed homeowners.

• Loan Modification:
  Your lender agrees to reduce your payments to an affordable level.
  
• Short Sale:
  The lender agrees that you will sell your home for whatever it can get in today’s market. If the sale price is less than the outstanding balance of your mortgage, the lender will forgive that amount.
  
• Deed in Lieu of Foreclosure:
  You hand the house back to the lender, and the lender agrees to not go through the foreclosure process. A lender will typically require you to attempt a short sale before considering a deed in lieu of foreclosure.
  
• Foreclosure:
  The lender takes back your house and sells it. Depending on your state the lender may be able to sue you for any loss it incurs if the sale price is less than the outstanding mortgage balance.
  

Please understand that the lender, not you, is in the driver’s seat here. What you want is irrelevant; this is all about what a lender is willing to offer you. Let’s walk through each option in detail.

Loan Modification

If you can prove you have financial hardship, a lender may be willing to reduce your current monthly payment to a more affordable level. I want to stress that this does not mean your principal balance will be reduced. While that is possible, banks have been loath to offer this relief. What is more likely—if you can even win a modification—is that your interest rate will be reduced to lower your payment.

The federal Home Affordable Modification Program (HAMP) offers lenders incentives to reduce the mortgage payments for qualified borrowers. Some lenders may have their own modification programs as well. The bottom line is that you want to start working with your lender as soon as you have any inkling you are headed for trouble. You do not need to be behind on your payments to qualify for the HAMP program; if you can prove financial hardship, such as a drop in your income due to a layoff, or the fact that your mortgage payment is adjusting to a new, higher cost that will make it hard to pay the loan, you may be able to win a reduction.

HAMP Basics

To be eligible for HAMP:

• The mortgage must be for a primary residence that was obtained before January 1, 2009. Vacation homes and investment properties are not eligible.
  
• The mortgage amount must be $729,750 or less.
  
• You must be able to prove financial hardship: Either your mortgage has increased or your income has decreased.
  
• Your monthly mortgage payment (including property tax, insurance, and homeowners’ association fees if applicable) must be more than 31% of your current gross income.
  

TIP:
In the summer of 2010 the Treasury Department, which oversees HAMP, introduced a new variation specifically for households in which a layoff has made it hard to keep up with the mortgage payment. The Home Affordable Unemployment Program (HAUP) offers a reduced payment for a short period while the household looks for reemployment. As with all of these programs, lenders are not required to participate, and so far it does not seem to be widely adopted. But please check with your lender to see if it may be willing to use HAUP to give you a temporary reduction in your mortgage cost.

If you meet all those criteria you may be able to win a mortgage reduction that brings your monthly payment down to 31% of your gross income. The HAMP website has a calculator that will show you an estimate of what your monthly payment could be if you win a modification:
www.makinghomeaffordable.gov
.

I need to be very honest here: To date this program has been a huge disappointment. Through the summer of 2010 only one-third of applicants who were given a “trial” modification were able to win a permanent modification. One of the issues was that the program initially enrolled participants before verifying their eligibility. In many instances lenders disqualified people during the trial period if they could not document financial hardship or their payments did not exceed 31% of gross income. A change in the program—effective in June 2010—requires verification of eligibility before a trial modification begins. What this means is that you will know early on if you are a bona fide candidate for a modification. However, the reality has been that many eligible homeowners are often being strung along for months—the average modification trial period in 2010 was about fourteen months—only to be turned down for claims of faulty paperwork.

And what is particularly upsetting is that when you go into a trial modification you could be making matters worse, as you’ll soon see.

The Risks of Asking for a Trial Modification

When a lender offers you a trial modification, your monthly payment will be reduced. That’s the good news. The bad news is that this will have a negative impact on your credit score. Why is this? Because even though the bank agrees to lower the payment, it must still report the fact that you are no longer paying the full amount due. So if you have been current on your mortgage and other payments, and you enter into a trial modification, be aware that your credit score is going to take a tumble. The hit your score takes will depend on your score prior to the modification. Unfair as it may be, a high score will actually fall more—possibly 100 points or so—while a lower score will not see as much impact.

The second risk is what happens if you are turned down for a permanent modification, a fact of life for more than two-thirds of borrowers who had gone through HAMP as of the summer of 2010. If you are deemed ineligible for a permanent modification, the lender can turn around and demand repayment for the difference between your regular payment and the trial payment.

Here’s an example: Let’s say you had a $2,000 monthly mortgage payment that was reduced to $1,500 during a 10-month trial period. Then the lender decides you do not qualify for the permanent modification. It can then demand that you repay the $500 monthly reduction you had for the 10 months. Suddenly you find yourself back at owing $2,000 to cover the monthly mortgage
and
you have a $5,000 balloon payment you must pay pronto. If you can’t handle both of those costs, the bank then starts the foreclosure process. In late 2010 the Treasury Department said it was looking into the balloon payment issue.

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.