Avoiding Foreclosure

November 12, 2008

This article addresses some of the options for homeowners (borrowers) facing defaulting loans and/or foreclosure. For more detailed information regarding your specific situation, contact a real estate attorney.

Notice of Default

When the borrower defaults on a loan payment, the lender will usually file a Notice of Default after the third missed payment. The Notice is filed with the County Recorder’s Office in the county where the property is located, and the bank will mail a copy of the Notice to the borrower and publish the Notice in a local newspaper.

However, a new California statute, Senate Bill 1137, enacted on July 8, 2008 (effective September 6, 2008 through January 1, 2013), requires banks to contact certain defaulting borrowers “in order to assess the borrower's financial situation and explore options for the borrower to avoid foreclosure,” and “advise the borrower that he or she has the right to request a subsequent meeting within 14 days, and to provide the borrower the toll-free telephone number made available by the United States Department of Housing and Urban Development (HUD) to find a HUD-certified housing counseling agency” (SB1137). This new law also requires banks “to wait 30 days after contact is made with the borrower, or 30 days after satisfying due diligence requirements to contact the borrower, as specified, before filing a notice of default” (SB 1137). This law only applies to loans made from Januaray 1, 2003 to December 31, 2007 that are secured by residential real property which is the principal residence of the borrower. As a result, certain defaulting borrowers now have some additional time to become more informed about their situation.

During this phase, a borrower typically has a few options, including the ones discussed below.

Forbearance or Modification of Loan Payments

A borrower may negotiate with the bank to forbear his loan payments for a finite period. The bank may consider this option if the borrower is able to convince the bank that he is facing a temporary monetary setback, but that he will be able to make regular payments in the near future.

Alternatively, if a borrower’s income has been permanently reduced, a bank may agree to modify the loan by lowering the monthly payment amounts, reducing the interest rate, and/or extending the term of the loan.

Generally, a bank is more willing to negotiate a loan modification, rather than simply letting the house foreclose, when the home owner has little equity in the property but wants to continue living on the property. This is because foreclosure is a costly procedure, and if the borrower has little or no equity in the property, which means that the borrower owes approximately the same amount – or more – than the fair market value of the property, the bank may suffer a significant loss through a foreclosure. This situation, also known as an upside down mortgage, can be especially prevalent where there is a negative amortized mortgage. In today’s economy, owners who purchased their properties at the peak of the housing bubble, now see a sharp decline in the value of their properties resulting in an upside down mortgage.

Workout Assumption

If the borrower has a qualified third party who is interested in assuming his loan, the bank may be willing to transfer the loan to the third party and relieve the borrower of any further obligation under the loan. Such a transaction may be performed with or without the borrower also transferring title of the property to the third party.

A workout assumption may sound like a great idea and may have been successful in the past when home values were rising, but is generally not realistic these days. A typical borrower will be unable to locate a third party willing to assume his mortgage in the current market. As discussed above, most distressed borrowers purchased their properties a few years ago when properties were overpriced compared to current prices. As a result, many home owners who default on their loans have a mortgage higher than the current fair market value of their properties. Thus, it often makes little business sense for a third party to assume a loan that is greater than the value of the property. However, a workout assumption may still be useful if the borrower has a generous relative or other benefactor who is willing to assume the loan to rescue the borrower from his precarious financial situation.

Short Sale

If none of the above strategies are realistic, the borrower may consider a “short sale.” A short sale is where the owner, with the bank’s approval, sells the property to a third party at the fair market value and the bank accepts the proceeds as full payment of the borrower’s loan. This scenario has some disadvantages for both the borrower and the bank. For the borrower, a short sale may affect his credit score (though this may be negotiated with the bank). For the bank, such a strategy will cause it to forgive a portion of the borrower’s loan balance.

However, the advantages to both sides can outweigh the costs. For the bank, the short sale usually results in a cost savings, as it will avoid administrative and foreclosure costs. For the borrower, especially if he is able to convince the bank to refrain from placing a derogatory mark on his credit reports, a short sale may enable him to save his credit rating and no longer obligate him to pay anything further on the property. Even if a short sale will negatively impact a borrower’s credit rating, the emotional impact and social stigma of this procedure is usually less traumatic than a foreclosure. This procedure requires the approval of all of the lenders, not just the bank that owns the loan upon which the borrower is defaulting and, if successful, the bank (or banks) will accept the short sale proceeds as full payment for the borrower’s loan balance.

Deed in Lieu of Foreclosure

The borrower may also request that the bank accept a deed in lieu of foreclosure. A deed in lieu of foreclosure is where the owner transfers title to the bank in exchange for a discharge of the loan obligation to avoid a foreclosure. However, banks may be reluctant to accept a deed in lieu of foreclosure, especially for properties located in volatile real estate markets, as doing so will result in the banks owning properties that they may have difficulty selling. However, even assuming the bank is willing to accept a deed in lieu of foreclosure, the borrower may still face some negative impact on his credit rating. However, as with a short sale, the emotional impact and social stigma of this procedure may be less traumatic than a foreclosure.

Foreclosure

In many situations, none of the above strategies may prove viable to the defaulting borrower. As a result, the borrower’s only strategy may be to “walk away” from his loan payments and await the foreclosure proceeding to take its course. One of the chief disadvantages of a foreclosure is that the borrower’s credit rating may be harmed.

After an owner receives the Notice of Default, it generally takes approximately three months before the foreclosure sale. During this time, the owner may remain on the property and strategize his future steps to finding a new home.

Right to Remain in Home after Default

Though the borrower may be in default of his loans and is facing imminent foreclosure, he has the legal right of possession of the property. This means that the borrower may continue residing at the property until after the property has been sold to a new purchaser, and until the new purchaser legally evicts him. Caveat: if the borrower waits until after the new purchaser serves him a legal eviction notice, the borrower may risk having an eviction (unlawful detainer) appear on his tenant history which may later cause the borrower problems in obtaining a rental.

© 2008 Szeto Law Group. These materials do not constitute legal advice and are for general informational purposes only. They may be reproduced for personal use and for non-commercial distribution. All copies must include this copyright statement.
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