There seems to be a debate between whether it is ethical to strategically default on your home mortgage. Where I personally land on the issue is probably irrelevant, but if you promise to read to the end you’ll get your answer as to what I believe. If you walk away from your credit card debt what happens? Does it go away? Nope. What about if you default on your student loans? Nope they don’t go away either. What about your auto loan? Nope, they repo and can still come after you for the difference. So how is it that homeowners can participate in a short sale or strategic default and not receive a judgment against them?
What is a Short Sale?
As most people are aware a mortgage is “a debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay back with a predetermined set of payments.” In other words you are taking on a loan which is secured by a note which is usually amortized over a certain amount of years, and since that note is secured by a piece of real property if that note is defaulted upon then the property will be the first thing taken.
There are three scenarios when you decide to foreclose on your home,
- If you owe $500,000 on your home and your house is worth $500,000…the bank takes the house back and everyone walks away with a fake smile.
- If, however, you owe $500,000 on your home and the house is worth (and ultimately sold at auction for) $1,000,000 then the bank must provide you with the surplus
- But what happens when you owe $500,000 and your home is only worth $350,000? Who is on the hook for that extra $150,000?
That shortfall is what creates the term, short sale; the term, which was once a taboo subject, now is common place. The National Association of Realtors provides a very basic and intuitive definition of a Short Sale,
A short sale is a sales transaction in which the seller’s mortgage lender agrees to accept a payoff of less than the balance due on the loan.
While the definition of a short sale is that simple, it is the repercussions that occur afterwards that differ State to State.
Is My State a Recourse or Non-Recourse State?
There are different remedies afforded to lenders who are securing the note with a piece of real property used as a residence as compared to an unsecured line of credit or even an auto loan, and these remedies differ state from state. From About.com,
Recourse loans get their name from the fact that lenders have power. They are allowed to go after you for amounts that you owe – even after they’ve taken collateral. If you default on a recourse loan, the lender can bring legal cases against you, garnish your wages, and try to collect the amount you owe.
A legal action to collect money after foreclosure is generally called a deficiency judgment
A non-recourse loan does not allow the lender to pursue anything other than collateral. For example, if you default on your non-recourse home loan, the bank can only foreclose on the home. They generally cannot take further legal actions against you. The bank is out of luck even if the sale proceeds do not repay the loan.
Non-recourse loans create the most risk for lenders. Because they can only collect the collateral – and nothing else, they want to see lower loan to value ratios to reduce their risk. These loans may have higher interest rates than recourse loans.
Is any of this news to the bank? Nope. If they are licensed to sell mortgages in the State, then they’ll know whether they are providing a loan in a recourse or non-recourse state. Do you know who is usually clueless? The mortgagor-borrower.
How do you determine if your State is a Recourse or Non Recourse State? I would check with a licensed attorney. That may seem like a “cop-out” but every resource that I have come accross on the Internet while researching this post, doesn’t seem to list every State, or is just plain wrong. You should also be able to check your mortgage documents.
This post was inspired by a comment from Crystal from Budgeting in the Fun Stuff (who freely rips on me for hating on teachers) on a post from Little House on the Valley
Oh c’mon Evan, can’t you work your attorney magic and give us the list of Recourse and non-Recourse states? 🙂
HA I don’t make enough money off the blog to look up EACH and EVERY State in the Union. But I like your site a lot so…what State do you live in?
This is exactly why I’ve never had a problem with people walking away from their mortgages. The lenders took the risk and in some cases they lost. In other cases they won. That’s business.
What I can’t understand is why any lender would lend a mortgage that is non-recourse without a large downpayment (ie 25% or more) and assurances that the house owner can’t borrow against that equity (ie using a HELOC).
I hinted at it, but never really said but that is also the reason why I am alright with people walking.
Lender’s took the risk – they knew the risk, if they ignored the risk too bad.
Do I feel bad for neighbors? Sure, but that’s not a reason to put one’s family in a worse position.
“What I canâ€™t understand is why any lender would lend a mortgage that is non-recourse without a large downpayment (ie 25% or more) and assurances that the house owner canâ€™t borrow against that equity (ie using a HELOC).”
Stupid question – Because Real Estate Never goes down LOL
I cannot stand how many people are walking away from their mortgages, even though they can afford it. But, the system is set up for them to, so it definitely isn’t illegal.
When we were on vacation, the condos we were staying in were selling in the mid 300s. You can now get them for 95,000. If I had bought one at 350,000 would I feel differently? Maybe I would I don’t know, but for now, it makes me mad.
This sounds like The Wife’s often argument of “Its unfair” lol
Nice post crystal. It seems that I cant go anywhere in the yakezie without finding one of your guest posts. Keep up the hard work!
Nope I Wrote it…She just inspired it
Well, the answer to the initial question — why are there even such things as short sales and foreclosures? — is that the structure and land are put up as collateral for the loan. The borrower gets to live in the building as long as he or she is paying up, but when a default occurs, the property is given to the lender.
While it’s very nice when the property is worth the same as or (usually) more than the amount lent against it, the lender is aware of the risk taken in lending money against a piece of real estate. Indeed, the lender is probably more aware of that risk than is the borrower.
Don’t forget the old adage: You don’t make money unless you take some risk.
The lender takes its chances when it lends against a piece of collateral. Most of the time, the lender wins: under normal conditions, real estate values at least keep pace with inflation, and often they exceed inflation, so that repossessing a house represents a profitable transaction.
However, we’re not living in normal conditions.
Lenders are aware that bad times come and go, and they’re aware that making a loan entails two gambles: a) that the borrower will pay according to the loan’s terms; and b) that the collateral will always worth the amount of the loan. That’s why mortgage lenders make you pay to have your property appraised before lending against it.
It’s as much the lender’s responsibility to realistically estimate the borrower’s ability to pay and the actual value of the collateral as it is the homeowner’s responsibility to pay the agreed-upon PITI. But part of the deal is that the lender gets your house if you can’t pay, so the fact is that accepting a house in foreclosure to end the deal is what the lender agreed to do.
You’re dead right that those websites purporting to tell you which states are and are not nonrecourse states conflict! Best bet is to ask a lawyer, your state legal aid society, or the state attorney general’s office.
It’s totally legit to walk away. The bank signed an agreement as collateral!
California, Nevada, and Florida are non-recourse states baby!
Nevada IS indeed a deficiency state. And, just to make it more confusing, the statute of limitations varies depending on whether the property was foreclosed upon, sold short or the lender accepted a deed-in-lieu of foreclosure.
All mortgages are deficiency mortgages? In New York it needs to be expressed in the loan which means most people don’t sign those loans lol.
Considering Nevada’s housing market is a DISASTER I can’t imagine the Court’s being able to handle all the proceedings
The sad (possibly unfair) part of it all is that those borrowers who got out early, slipped through the cracks of an overwhelmed system. The lenders now have more staff and seem to be better able to handle the deluge of delinquencies, short sale requests and foreclosures. I wouldn’t hang my hat on not being sued because the lender is too busy.
From the better late then never file:
During the 2009 legislative session, the Nevada law was changed so that a loan made by a bank to a borrower who has continuously lived in the property and never refinanced is non-recourse.
It may be legal, but is it ethical? Maybe in some cases. I think my point was that people are walking away from their homes because “everyone else is” – it’s a mass mentality at work. I’m not so sure it’s the best option for everyone opting for it. Someone close to me has started this process (but they haven’t researched it completely yet) and are under the impression they’ll be able to purchase another house in just a few years time.