THE FINE PRINT – January 2013 Issue
Underwater Loan Modifications: Just Kicking the Mortgage/Housing
Crisis Can Down The Road?
Question:
I have one loan against my home which has a balance substantially greater that
the current market value. I am in default on the loan, in danger of
foreclosure, and have received an unsolicited long term loan modification,
which does not include any principal reduction term. Should I accept it?
Answer: As
with everything, the answer depends upon the terms of the long term loan
modification. However, a number of general points can be made for your
consideration as you determine whether to accept the long term loan
modification or not. What is important is that you fully understand what you are
being offered, and where you might find yourself some years down the road with
such a loan obligation, as modified, in place, and to also realize that
lender's proposal is likely not being made with the best interests of the
homeowner in mind.
The following discussion
is based on one true life example of a long term loan modification of a loan
secured by a first position trust deed against the borrower's primary residence
in Bend , Oregon
homeowner?:
A. The loan term was extended
out to 40 years, running from the date of the loan modification.
B. The interest rate was
reduced to 4.625% fixed for the entire 40 year term.
C. Approximately $53,000
of the new loan balance was put into what is referred to as a "Deferred
Principal Balance", and it was provided that no payments would have to be
made on this amount, and no interest would run on it. However, this Deferred
Principal Balance would have to be paid in full if the homeowner sold the
property, or the homeowner defaulted under the loan and the debt was
accelerated, or upon the new maturity date 40 years from now.
D. The new monthly payment
of principal and interest was $1,114. Interest
is not run on the Deferred Principal Balance. If interest was run on the true
principal balance, the loan would be negative amortizing - meaning the loan
balance would actually increase over time. The homeowner also has to make
estimated monthly payments of property taxes and insurance into a reserve
account.
To give additional
perspective to the factors discussed below, here are two numbers for the loan
balance in the future:
a. After 7 years, in
January, 2020, the unpaid balance would be $278,000.
b. After 15 years, in
January, 2028, the unpaid balance would be $250,000.
What has been accomplished
with the acceptance of this long term loan modification? The homeowner gets to
stay in the home, is able to avoid the time and expense and hassle of having to
move and find a new home to live in, but has effectively become a renter (as
there is no equity in the property). But unlike a true rental situation, the
downside to the homeowner is that the legal liability associated with the loan
continues for the long term. And unless the homeowner is going to stay in the
property for a substantial period of time, at some point in the future, the
homeowner is still going to face the decision of having to go through a short
sale or foreclosure, with all of the negative consequences associated with
those processes.
What factors should the
homeowner consider, or what questions should the homeowner be asking, as the
proposed loan term modification is being considered? The following includes my
assessment of whether the particular factor is a positive (PRO) or negative
(CON) in making the decision about whether to accept a proposed long term loan
modification.
1. What are the
projections for housing prices? Obviously no one has a crystal ball, but you
should be able to get some general idea of the direction that prices are
headed, and what the expectations are for the housing market in the area the
home is in. If prices are headed in the negative direction, or in a positive
direction, but at a tepid pace, say a few percent a year, then it is: CON.
2. Under somewhat of a
best case scenario analysis, how long would it take for the market value of the
home to reach the level of the debt against it? Or, putting it differently,
what percentage increase each year would the home have to appreciate in value
in order for the home's market value to be equal to the debt against the home
after, say, seven years? (I use seven years because that is the historical
average for a person staying in the same home). If at the end of seven years,
the homeowner is still going to have a loan which exceeds the value of the home,
then it is: CON.
3. Would the homeowner be
better off, financially, to take the credit hit now, rather than waiting until
some time down the road? If the homeowner is already in default, the credit hit
has already occurred, and perhaps there are other events which have occurred
resulting in the homeowner having a low credit score today, and the expectation
is that the future will be better and the homeowner will be repairing their
credit over the next number of years, then this is a negative consideration for
accepting a modification, as the deferral of the major adverse credit
consequence of a short sale or foreclosure will now occur at a point in time in
the future when otherwise the homeowner has been doing well. Overall: a CON.
4. A refinance in the near
future is likely out of the question, given the value of the property being
less than the amount of the loan, unless the homeowner brings money to the
table to buy down the loan, so the opportunity to take advantage of low
interest rates on any refinancing is likely non-existent. CON.
5. What are the current
tax ramifications of a short sale of the property or a foreclosure sale versus
what might exist in the future? For
example, if the home is the primary residence, the exclusion of the
1099 discharge of
indebtedness income could be available through the federal Mortgage Forgiveness
Debt Relief Act. That legislation may not be around several years from now (it
was just extended only for only one year, until December 31, 2013). Likely a
CON.
6. What are the tax
ramifications of a reduced interest rate?
Ordinarily, this would be viewed as a good thing, as out of the monthly
payment, the principal balance would be paid down more quickly. But in the
context of a substantial underwater property, I believe it could be argued that
the homeowner would be worse off, because of the reduced deduction for mortgage
interest payments, while the homeowner would be paying more towards paying down
principal on a loan which ultimately doesn't help the homeowner. In fact, one
could argue that in any such modification, the homeowner would be better off
having an interest only payment for a long term loan. Overall, a CON.
7. What will be the mind
set of lenders years from now? Currently, lenders are readily approving short
sales at substantial discounts (seriously, in many cases in the hundreds of
thousands of dollars), and with a full waiver of the claim for a deficiency,
and without requiring contributions by the homeowner. Short sales are also
still the best opportunity currently to rid one of the debt of a second
position loan, such as a HELOC, and again with a full waiver of the claim for a
deficiency. Will the lenders still be willing to do this in the future, once
the economy begins to change and the rate of foreclosures or short sales
diminish? Probably a CON.
8. If the homeowner cuts
their loss now, takes the credit score hit, and immediately begins to improve
their credit, would this enable the homeowner to perhaps more quickly purchase
a new home at the lower purchase prices and low interests rates which now
exist, and probably will for at least the next few years? I believe the
homeowner would be better off doing so now, rather than later, so this is a
CON.
9. What are the odds that
the homeowner will have to move out of the home within a short period of time
(say within five years), either because of a change of job, or change of income
level, or having outgrown the home because of new family members? A CON.
10. Does the homeowner get
to stay in their home, and avoid having to move and find a new place to live?
Yes. A PRO.
11. What about the amount
of the new monthly mortgage payment, compared to what a rental payment amount
might be for the similar properties? Remember the monthly interest and
principal payment is only one of many obligations of the homeowner who
continues with the loan. There is the additional monthly payment of the real
property taxes and insurance reserves. There is also the costs associated with
the maintenance and repair of the property, and potential capital improvement
costs over time, which would not be the responsibility of the lender, but the
homeowner, under the continued home ownership scenario, but would not be the
homeowners obligation as a tenant. Factoring all of these costs in, it is
possible that the true monthly costs for continuing home ownership exceed the
costs of a rental. A slight toss up, but I'll go with a CON on this one.
Notwithstanding all of the
negative considerations, in the short term, it is understandable that the
homeowner would accept the proposed loan modification, as the homeowner avoids
the immediate dislocation associated with having to move out of the home, and
find a suitable replacement home - whether as a purchase or as a rental. But
for the long term, I would argue this is a very poor bargain for the homeowner,
primarily benefits the lender, and will be a decision the homeowner ultimately
regrets. To emphasize, however, the long term loan modifications I am
addressing do not include principal reduction components. If a proposal
includes a principal reduction component, bringing the new principal loan
amount down to current market value, then a completely different analysis would
be warranted - but those types of loan modifications are very few and very far
between.
Finally, what about the
big picture? What does such an arrangement have on the general economy and the
still existing housing/mortgage crisis? As noted in the title line, the can is
just being kicked down the road. The underwater loan will in all likelihood
have to be dealt with at some point in time, and either a short sale or
foreclosure will occur. Nothing will have been avoided - the problem's
resolution just postponed for all of us to have to deal with over the years to
come.
Ambrose Law Group LLC
200 Buddha Building
312 NW
Direct Dial: 503.467.7237
Direct Fax: 503.467.7238
drambrose@ambroselaw.com
Disclaimer: this column does not constitute the
giving of legal advice, and your reading this column does not create an
attorney/client relationship. You are encouraged to consult a lawyer or
accountant should you have questions about how this information may be
applicable to your particular situation.
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