Before we get started, let me explain the foreclosure process. Foreclosure is the process by which a lender that holds a mortgage or in some states, a deed in trust, seeks to sell the house and apply the proceeds from the sale to satisfy all or a part of the debt owed by the owner to the lender. So before we talk about foreclosure, you need a house or other real property owned by you. You have borrowed money from a lender and have agreed to pledge the real property as collateral to secure the lender’s repayment. The “pledge” is in the form of a mortgage or deed of trust. Going forward, we’ll just refer to it as a mortgage.
When you borrow the money from the lender, you typically, sign and give the lender a Mortgage Note. The Mortgage Note is a promissory note that represents your monetary obligation. Going forward, we’ll call the Mortgage Note, the “Note.” The mortgage is the security or pledge of the real property itself. When a person defaults in paying, we often say he or she is behind on the mortgage. Such an expression, though readily understood to mean the borrower has missed payments due the lender, is not technically correct. In actuality, the person is behind or in default in making the payment required by the Note. The lender then, in accordance with its rights under the Note and the Mortgage, can declare the Note in “default.” The default then triggers the lender’s remedies and options it may pursue to enforce payment of the debt.
When the lender declares the “default” it does so by sending written notice to the person or persons who signed the Note (the are called “makers”). In that notice, the lender informs the person that because the payment was missed, the lender is “accelerating” the required payment of the Note such that the entire principal balance, plus all accrued interest, as well as late fees and attorney fees has become due.
At this point, the lender has options as to the method it seeks to enforce payment. In most states, the lender can simply ignore the real property pledged by the mortgage and sue the persons who signed the note in state court to obtain a money judgment for the unpaid debt. The lender, once reducing its claim to a state court judgment, seeks to enforce payment by attempting to seize property, levying on bank accounts of the person or attempt to garnish their wages though a wage garnishment severed on their employer.
When the lender holds a mortgage, foreclosure of the mortgage has historically been a much easier remedy to pursue collection of the debt. Foreclosure is a remedy controlled by the laws of each particular state so the exact process varies from state to state. For our purposes, there are a couple of distinctions you should understand, as well as a couple of key common elements that are important.
Foreclosure by Advertisement is the common form of foreclosure pursued by a lender. It works typically like this. The lender publishes a foreclosure notice in the legal newspaper that covers the county where the property is located. The publication notice establishes a “sale date” or “auction date” for the property, includes the legal description of the property and the amount of the indebtedness to the lender that is presently outstanding. The sale is usually conducted by the county sheriff at a designated location – often times the county courthouse. At the sale, the highest bidder for the property receives a “Sheriff’s Deed” to the property entitling him to ownership of the property subject to certain limitations or redemption rights as explained below depending on the state’s foreclosure law. More often than not, the only person who appears at the auction is the lender. Since the lender is owed the debt, the lender can bid up to the amount of the total unpaid indebtedness without having to tender the money since it is the lender who is owed the money. Other bidders must actually tender the funds for the awarded bid price at the sale.
In Michigan and several states, after the sale date, the foreclosed owner has a “Statutory Redemption Period” which allows the foreclosed owner to retain possession of the property for a period ranging from 6 months to a year depending on how much of the original loan was paid prior to the default. Some states provide that the right to possession terminates if the property is abandoned by the owner and in some states if the property is farm land, the redemption period is longer. During the “Statutory Redemption Period,” the foreclosed owner can also “redeem” the property by paying the amount of the bid price at the auction, plus costs, insurance and accrued interest from the sale date.
In some states, there is no post sale/auction redemption period. These state’s provide the foreclosed owner an opportunity to retain the property but the period is referred to as the “Equity of Redemption Period” and runs from the time the lender declares the default up to the date of sale. The “Redemption” remedy sounds better than in actuality because people facing foreclosure are not typically in a cash position to tender the necessary money and their disadvantaged position makes it virtually impossible to borrow money.
In addition to Foreclosure by Advertisement, the lender can also pursue what is referred to as “Judicial Foreclosure,” which functionally accomplishes the same objective but differs in that the lender must actually commence a lawsuit in state court to gain the necessary authority to sell the property and dispossess the owner from possession. Some states, such as Florida do not permit Foreclosure by Advertisement only allowing judicial foreclosure. For purposes of our discussion, the distinction between judicial versus advertisement has little significance.
So let’s summarize. The lender holds a mortgage on your property which is a pledge of the property as security for repayment of the Note you sign when you borrow the money to purchase or refinance the property. The lender has two remedies it can pursue when you fail to pay. It can sue on the Note or it can foreclose.
Let’s examine how the process unfolds from the lender’s and owner’s perspective. If the lender forecloses on the house and bids at the sale the amount of the unpaid balance on the Note, the debt is extinguished. In this case, the debt is satisfied because the bid price equaled the unpaid debt. This is commonly called a “Full Credit Bid.” There is no shortfall in this situation and no exposure of being sued by the lender for the difference between the unpaid balance on the note and the value of the property as of the date of the auction sale. On the other hand, if the lender is the only purchaser (bidder) at the auction sale and bids less than the amount of the debt, in this case, the lender can pursue a claim against the foreclosed owner for the deficiency – the difference between the price bid by the lender and the unpaid balance on the Note. To preserve this claim, the lender normally has a market value appraisal of the property conducted in close proximity to the auction sale and then bids a price equal to the appraised value at the auction sale. The lender can then attempt to collect this deficiency by filing a law suit in state court against the foreclosed owner seeking a judgment for the deficiency.
Deeds in Lieu of Foreclosure and Short Sales coupled with a release from the lender are methods by which homeowners seek to shed themselves of the underwater home but at the same time eliminate the potential exposure of a deficiency claim being pursued against them by the lender. If, however, the market value of the home is in close proximity to the unpaid Note balance, a homeowner can proceed with the assumption that the bid price by the lender will extinguish the debt secured by the first mortgage. In that case, the concern of exposure from a claim for the deficiency is not significant.
From a planning perspective, you have to evaluate the risk and likelihood that a lender, in foreclosing on the house, will seek to pursue a deficiency claim. Here a major distinction exists between the lender holding the first mortgage compared to HELOC and other second and junior mortgage lenders.
Second and Junior Mortgages
When you have a second or multiple mortgages, the pledge to the lender holding the second or later mortgage provides far less protection, particularly in the depressed real estate market of today where property values have dipped so low that the market value of the homes is consistently less than the first mortgage and certainly inadequate to cover both or all of the mortgages. The mortgage lenders receive their priority based on when the mortgages are recorded and issued. Second and third mortgages are often called “junior mortgages” or “junior liens.”
To understand the process and anticipated responses you will receive from the lenders holding junior mortgages, it is helpful to understand the rights of the junior mortgage lender compared to the rights of the first mortgage lender. When a first mortgage is foreclosed, the property will be sold to the highest bidder. If the sale price is equal to or greater than the amount of the unpaid Note secured by the first mortgage, the excess would flow to junior mortgage lenders according to their priority. For example, assume the balance on the note secured by the first mortgage is $200,000, and the balance on the note for the second mortgage is $50,000 and there is a third mortgage and note also for $20,000. If the bid at the auction on the foreclosure of the first mortgage is $260,000, then $200,000 goes to payoff the first mortgage lender, the second mortgage lender gets the next $50,000 and the third mortgage lender gets the remaining $10,000. In this instance, the only exposure left for the foreclosed homeowner is a suit from the third mortgage lender which only received $10,000 against the $20,000 balance. A result such as this, however, in the current market, rarely occurs.
The common example is that you have the same $200,000, $50,000 and $20,000 three mortgages, but the value of the property as of the foreclosure sale is $200,000 or slightly less. Typically, the bidder at the sale is the first mortgage lender and it will bid the unpaid balance it is owed (or less if it intends to pursue a deficiency). This means, if the second mortgage lender or any other junior mortgage lender wishes to protects its interest in the security value of the property, they have to purchase the property at the foreclosure sale which requires them to tender cash equal to the first mortgage lender’s balance and any other liens having priority to their lien (i.e. if the third mortgage lender wants to protect itself, it must tender cash to take out the first two mortgage lenders). The junior lender who purchases at the foreclosure sale must then wait to regain possession of the property for any applicable redemption period to run. After that occurs, it then must reclaim the property, repair the property and ultimately sell the property for more than the amount it has paid at the auction sale, plus holding costs and repairs in order to realize any money against the original unpaid balance of the junior mortgage note.
Needless to say, in contrast to the holder of the first mortgage, junior mortgage lenders have a difficult road to follow in order to recoup the loss exposure on a junior mortgage note. This difficult road has consequences. In the quest to shed debt and rid oneself of a house that is underwater in value compared to the mortgage note balances, the junior mortgage lenders are more difficult to deal with because they are not positioned to recover any money from the sale of the property. The distinction is that it is easier for the first mortgage lender to take a partial loss on the transaction and forego chasing the owner of the deficiency compared to the junior mortgage lender agreeing to receive nothing. Bottom line here – the junior mortgage lender is not going to give up its claim for nothing. Keep in mind, the junior mortgage lenders are not in a position to receive anything from the sale of the property because the first lender will receive those proceeds. The junior mortgage lenders, can, as we’ve discussed, sue the owner for the unpaid balance on their Note.
Foreclosure as a Tool
Now that you have a basic understanding of the foreclosure process and the varied interests of the players, let’s identify how “foreclosure” is a tool in Financial Crisis Management. Here’s how. If you’re way underwater on a house, the goal is not to modify the mortgage loan. The goal is to “shed the debt” which means get rid of the house and then mortgage note obligations, and then to find a new house that is similar in style or otherwise meets your needs at the then current market price of houses. In this setting, foreclosure of the first mortgage is a tool because it allows you to extinguish the debt on the first mortgage Note and to live in the house without cost (other than utilities) for a sustained period preceding foreclosure, during the foreclosure process and during the redemption period. I often call this, “Getting Your Equity Out.” Suppose your mortgage payment was $2,500 per month and you purchased a $300,000 home with 10% down and a $270,000 mortgage.
Assume now, the house is only worth $200,000. Well – obviously you have no equity in this home since its $70,000 underwater on the mortgage and you’re $100,000 short from the value when you purchased it. Nevertheless, when you purchased it originally, before the Financial Crises, you had $30,000 of equity represented by your down payment. “Getting Your Equity Out,” when I use these words, really means saving the money represented by the mortgage payments you are not making throughout the foreclosure process. A twelve month period, in most states, is very likely from start to finish. In this instance, 12 months x $2,500 = $30,000 – the equity you lost in the crisis.
Of course – the banks and probably the government would not like the gloss in this analysis, but two things must be kept in mind. First, no one is knocking on your door to help you. Second, the loss you’ve incurred is real and just as the banks and major businesses are taking steps to insure their recovery – you need to do the same. Now I recognize, in many situations the house owner has suffered an income decline due to job loss or business failure and in that case, the mortgage payments that are not paid to the lender will not be saved because the money is simply not there. But remember, we’re talking tools here. In the case of a person who is underwater in their house, in the right situation, foreclosure can be a tool to allow them to exit from the house obligation to the lender and provide a means to save money for a future purchase or lease with option to purchase of new house or other investment.