When is Foreclosure Right for You? Part 2 of 2

This post is not legal advice. It is a general discussion of SOME of the relevant legal issues surrounding foreclosure. If you are considering or facing foreclosure, you need specific legal advice for your particular situation. Consult an attorney in your area.

In my last post, I discussed the difference between a judicial and a nonjudicial foreclosure, which is one of the two essential issues to understand when considering whether to allow your property to go into foreclosure. The other essential issue concerns the number of mortgages you have on the property.

For many reasons, people often took out a first and a second mortgage when they bought property. Others opened up a home equity line of credit which they then used to pay other bills. In either case, the owner has a first and a second mortgage on the property. Where there are two mortgages, foreclosure creates much greater risk.

First, some background: mortgages, like all other liens, are arranged by seniority. (A “lien” is a legal right to force the sale of particular property to repay a debt, whether on a mortgage, unpaid property taxes, an unpaid contractor’s bill, etc.) As a very general rule, seniority is determined by time; the older the lien (i.e. the longer ago it was created or placed on the property), the greater the seniority. The “first” mortgage (or any other lien) — known as “first position” — will be paid in full by the sale of the property before the second and all subsequent liens are paid. The second will be paid in full before the third and all subsequent liens are paid. The third will be paid in full before the fourth, and so on. So, in a market like this one, the only debtor who has any real chance of being repaid in full is the mortgage or other lien in first position.

Where an owner has two mortgages, one is senior to the other (usually in first and second position on the property). Typically, when an owner stops making payments on these mortgages, the first position mortgage will foreclose. By foreclosing, the first position mortgage (under authority created by the deed of trust) forces the sale of the property and the proceeds (after payment of costs) are used to satisfy the debt. If there are any remaining funds (very unlikely in today’s market), they are applied to the second position mortgage and then to the remaining liens in order of priority.

Now, here is the important part: foreclosure extinguishes the debt that is being foreclosed, but it does not extinguish the junior debts (such as a second mortgage). So, if the lender forecloses the first mortgage and the proceeds are insufficient to pay the total amount due, the balance is extinguished as a matter of law (with certain tax implications — perhaps the topic of a future post). In other words, even though the debt was not repaid in full, the debtor is off the hook and does not need to pay the difference on the first mortgage.

However, the debt of the second mortgage survives. Admittedly, the second lender can no longer foreclose on the property because the legal right to do is extinguished by the foreclosure of a senior debt. The problem for the owner, though, is that he still owes the money borrowed under the second mortgage. In WA, you have six years in which to sue for breach of contract. The owner/debtor’s failure to make payments on the second mortgage (per the terms of the promissory note) constitutes a breach of contract. So, after foreclosure of the first, the second lender will have six years in which to sue the debtor for the full amount of the debt. The debtor will probably lose that suit. At the end of that process, the lender will have a judgment against the debtor for the full amount of the balance due, plus interest and late fees, plus attorney’s fees and costs incurred by the suit. Judgments are bad (see Part 1).

So, if you’re thinking about foreclosure, you’re taking a very big risk if you have multiple mortgages. You could get a very, very unpleasant surprise five years later. At that point, bankruptcy may be the only viable option.

When is Foreclosure Right for You? Part 1 of 2

This post is not legal advice. It is a general discussion of SOME of the relevant legal issues surrounding foreclosure. If you are considering or facing foreclosure, you need specific legal advice for your particular situation. Consult an attorney in your area.

Practically every day, I get a call from a potential client wondering what to do with a property that is seriously “under water.” A property is under water where the owner owes more on the mortgage(s) than what the property is worth in today’s market. The problem can be compounded by high mortgage payments (in the go-go market of yesteryear, it was not uncommon for someone to buy “more house” than they needed in the hopes of continued double-digit appreciation — the more expensive the asset, the greater the total appreciation). At least once a week, I speak with someone who has mortgage payments of $3000+ per month, where they could rent a suitable place for half that and they owe $50,000+ on the property beyond what it is worth.

So what to do? It’s been the topic of some discussion. One option is to hunker down, bite the bullet, and wait for the market to bounce back. After all, you’ve got to live somewhere. Eventually, the market will start going up and some day you’ll regain equity in the property (equity = value in the property greater than what is owed on it). However, depending on when you bought and what you paid, it may be a loooooooooonnnnng wait…. In the meantime, you’ll keep making those big mortgage payments.

Some people wonder whether they can just walk away from the property and be done with it. The usual plan: Let it go to foreclosure, temporarily ruin your credit, and start saving the difference between rent and the mortgage. To determine whether this is a good idea — or, more accurately, to get an idea as to the risks and benefits of doing so — you must first understand the difference between a judicial foreclosure and a nonjudicial foreclosure. [Author’s Note: This post is written for residents of Washington State. If you live somewhere else, your laws may differ. Yet another reason to consult an attorney.]

First, some background: When you bought the property, you borrowed money from a lender. In doing so, you signed two key documents: a promissory note, and a deed of trust. The promissory note is the legal document that sets forth the debt and the terms of repayment. The deed of trust is a type of deed (a document that transfers title to real property). Under a deed of trust, you transferred title to the property to a trustee, who “owns” the property for the sole purpose of guaranteeing that you repay the debt as set forth by the promissory note. If you fail to pay the debt, the trustee has the power to sell the property without your permission so that the proceeds of the sale can be used to repay the debt.

Now, the two types of foreclosure: A judicial foreclosure is a civil action filed in court by the lender. The lender sues for payment of the debt reflected by the promissory note. The process takes 12+ months and is expensive. At the end of the process, the court will order the sale of the property, the property will be sold at public auction, and the proceeds from that sale (after costs incurred) are applied to the amount owed. If there is a balance remaining on the debt, that difference becomes a judgment against you. This is a “deficiency judgment” because it is a judgment for the deficiency between the amount paid (via the sale) and the amount owed. A “judgment” is a court order requiring a person to pay a specific sum, and if not paid immediately it accrues simple interest at 12% until paid. A judgment expires 10 years after it is entered by the court, but it can easily be renewed for another 10 years. Once a creditor has a judgment, the creditor can use various legal tools to extract payment from the debtor without the debtor’s consent. For example, the creditor can garnish the debtor’s wages (the employer pays a portion of the wages directly to the creditor) or garnish the debtor’s bank account (the bank disburses the funds in the account directly to the creditor). It is safe to say that judgments are bad. So, one should avoid a judicial foreclosure.

The other type of foreclosure is a nonjudicial foreclosure. With this type of foreclosure, the trustee orders the sale of the property under the authority conferred on him or her by the deed of trust. Once again, the proceeds (less costs of sale) are applied to the debt owed under the promissory note. This process is quicker and cheaper than a judicial foreclosure. However, a nonjudicial foreclosure extinguishes the debt set forth in the promissory note, even if the sale does not net enough to repay the debt in full. There is no possible deficiency judgment. Thus, with a nonjudicial foreclosure, the debtor knows that he or she will not owe anything following the foreclosure, regardless of whether or not the lender is repaid in full following the sale.

Obviously, then, foreclosure may make sense if the lender foreclosures nonjudicially, but probably does not make sense if the lender forecloses judicially. Which will happen to you? Unfortunately for debtors, lenders do not advertise in advance which method of foreclosure they intend to use. That said, the vast majority of foreclosures are nonjudicial. A judicial foreclosure would make sense for a lender if the debtor has other assets that can be used to satisfy the deficiency judgment. If the debtor has no other assets, then they are “judgment proof” (a term used to describe someone who simply has no money to satisfy a judgment, thereby discouraging anyone (including a lender) from incurring the costs of a lawsuit). Where the debtor is judgment proof, it makes no sense at all for the lender to incur the costs of obtaining a judgment.

So, if you’re willing to assume the risk of a judicial foreclosure, and/or you have no assets whatsoever such that you are comfortable being judgment proof, then it may make sense to just walk away. [Note: you’ll have a hard time getting credit, finding a landlord, or otherwise living in the modern world if there is an unpaid judgment against you.] However, this is only ONE of the TWO key factors you need to consider. Stay tuned for Part 2.