The Wall Street Journal reported in its aptly named article House Is Gone but the Debt Lives On that lenders and/or third party debt collectors are suing borrowers for deficiency judgments.
This is not a new issue. This has been a growing concern among borrowers. There is a dawning realization that if a property cannot pay off the mortgage loan balance in full then the borrower will be responsible for the shortage. We talked about deficiency debt in our March 2010 post entitled Plan To Be Followed When You Walk Away From Debt. As predicted, there has been an increase in lawsuits for deficiency judgments.
This current post focuses on principles and strategies that can be a guide towards resolving deficiency debt.
A deficiency debt arises when a property sold at a foreclosure auction cannot generate enough proceeds to pay off the entire loan amount. If a lender can prove to a court that a borrower is personally responsible for the payment of a deficiency debt then the lender can obtain a deficiency judgment against a borrower. A deficiency judgment is a court order that directs a debtor to pay the lender a certain amount of money. A deficiency judgment includes the principle balance, unpaid interest, legal fees, escrows, and/other costs. A deficiency judgment allows the lender to collect interest until the balance is paid in full. It provides a lender with various tools to collect the judgment such as the right to garnish wages, the right to place a hold on a bank account, and the right to place a lien on personal property or real estate. A deficiency judgment can appear on a credit report. If you are not clear about deficiency debt please read the article What Everyone Should Now About Debt Forgiveness, Obligations, and Deficiency.
There are three alternatives that can arise from the auction of a property at a foreclosure sale:
- The property is sold to the highest bidder or,
- The lender takes the property in full satisfaction of the debt or,
- The borrower redeems the property by paying in full at auction.
If a lender takes the property at an auction then there is no deficiency debt arising from the loan made by the lender. If the lender decides to take a cash bid at an auction, instead of the property, then the borrower may be responsible for the difference between the total amount due on the loan and the amount collected from the cash bid.
Keep in mind that an auction may not always eliminate a second mortgage and/or Home Equity Line of Credit ("HELOC"). A foreclosure auction typically deals with the loan that is the subject of the foreclosure lawsuit. A foreclosure lawsuit is usually started by the first lien mortgage lender. A borrower can still remain liable for a second mortgage and/or HELOC after the first lien mortgage lender takes the property at an auction.
Each state has specific laws governing the collection of a deficiency debt. In some cases, states prohibit the creditor from seeking more than the collateral used to secure the loan. This is called “non-recourse” or “anti-deficiency.” This means that a creditor cannot hold the borrower personally liable for more than the value of the property at the time of sale. In a “recourse” jurisdiction such as Ohio, if a borrower owes a lender an $100,000 deficiency after a foreclosure sale, then the lender can sue the borrower for the difference, i.e., get a deficiency judgment against a borrower. You can learn more by reading What Is The Difference Between Non-Recourse and Recourse States.
The WSJ article contained important points which should serve to remind all strategic defaulters about the need to develop a written action plan. The following are the main points from the article:
• "Forty-one states and the District of Columbia permit lenders to sue borrowers for mortgage debt still left after a foreclosure sale."
• "Foreclosed homes seldom fetch enough to cover the outstanding loan amount."
• "$100,000 was roughly the average amount by which foreclosure sales fell short of loan balances in hundreds of foreclosures in seven states reviewed by The Wall Street Journal."
• "64% of the 4.5 million foreclosures since the start of 2007 have taken place in states that allow deficiency judgments."
• "Some lenders say they are more likely to seek a deficiency judgment if they perceive the borrower to be a 'strategic defaulter' "
• "Sharon Bock, clerk and comptroller of Palm Beach County, Fla., expects a massive wave of these cases as banks start selling the judgments to debt collectors."
• "the judgments sell for only about two cents on the dollar, versus seven cents for credit-card debt, according to debt-industry brokers."
• "Investors know that most states allow up to 20 years to try to collect the debts, ample time for the borrowers to get back on their feet. Meanwhile, the debts grow at about an 8% interest rate, depending on the state."
• "Florida is among the biggest deficiency-judgment states. Since the start of 2007, it has had more foreclosures than any other state that allows deficiency judgments."
• "Credit unions and smaller banks are the most aggressive pursuers of deficiency judgments, a review of court records in several states shows."
• "The biggest banks appear to have stayed largely on the sidelines as they deal with the foreclosure-paperwork mess. One big bank, J.P. Morgan Chase & Co., 'may obtain a deficiency' judgment in foreclosure cases but will 'often waive" the leftover debt when a homeowner agrees to a so-called short sale of a house for less than is owed on it, a bank spokesman says."
The WSJ article points out the new economic reality of deficiency debt. It is profitable for third party debt collectors to purchase deficiency debt and to chase the borrowers for payment. For example, if a third party debt collector purchases an $100,000 deficiency debt or judgment for $2000 (two cents on the dollar!!) then the third party debt collector is prepared to wait as long as it takes for a borrower to get back on their financial feet, especially a strategic defaulter. In the prior example the third party debt collector purchased the right to collect $100,000 for only $2000. A debt collector does not have to sue for a deficiency judgment. The third party debt collector can offer the borrower a debt settlement of $15,000 to be paid over 3 years. The third party debt collector can choose any amount and/or term it desires so long as money is made. Many lenders and/or third party debt collectors have access to a borrower's financial profile. The borrower’s financial information can come from credit reports, property records, bank accounts, business information, tax returns, and/or financial documents sent to a lender to apply for a loan work out. The financial information gathered by the creditors can be used to strategically target borrowers with a higher chance of repaying the debt.
So let's focus on actionable principles and strategies for dealing with deficiency debt. One rule underlies the following strategies: You must act now to implement the strategies. The overall economic outlook is generally negative. It is in your best interest to get your financial house in order RIGHT NOW before it becomes more difficult down the road.
Principles and Strategies For Dealing With Deficiency Debt
- It takes patience, perseverance, and hard work to prepare a proper deficiency debt defense. In addition to your own personal research and information gathering, you should seek the advice of a competent attorney and tax advisor. The attorney will provide you with an overview of the legal risks and strategies. The tax advisor will discuss any tax obligations that may arise from deficiency debts.
- Read the ever evolving Principles of Debt Defense. These principles require action. If you commit to the action, you will see positive results.
- Keep in mind that it is difficult to defend a deficiency lawsuit. It is a straightforward lawsuit that can lead to a lender obtaining a deficiency judgment once the lender can successfully prove its case in court. A deficiency lawsuit is based upon a borrower’s signed written agreement (aka Promissory Note or Note) to be personally liable for the loan. Generally, if a lender or assignee of the loan can establish 1.) that it actually owns the loan, 2.) that an actual amount of money was loaned to the borrower, 3.) that the borrower signed a document agreeing to pay the loan (aka Promissory Note or Note) to the lender, and 4.) that the borrower stopped making payments on the loan then it becomes almost impossible for a borrower to successfully claim "I didn't borrow the money from the lender and I don't owe the money". An assignee of the loan is any other person or entity, other than the original lender, that has become the new owner of the original loan.
- Fight, fight and fight. Just because a deficiency lawsuit is tough to defend does not mean you should not defend it. You should never make it easy for the lender to get your money. A strong defense can either prevent the collection of the debt or can lead to a reduced settlement of the debt. It can provide you with time to gather your resources so you can pay the lender in full. It may even lead to a loan modification.
- Make an attempt to settle the debt with the lender before it turns into a lawsuit. In many instances lenders are willing to accept settlements of ten cents to fifty cents on the dollar. In fact you will increase your wealth with the successful settlement of a debt. For example, let's say you borrow $100,000 and you make an agreement with the lender to settle the debt for $15,000. This leaves an unpaid balance of $85,000. In most settlements, the lender will agree to forgive the unpaid balance which in this case is $85,000. States and the IRS have created rules regarding forgiven debt. Normally forgiven debt is considered taxable income. In some instances the IRS does not tax forgiven debt. However let's say that there is a tax on the $85,000 in forgiven debt. Let's say the total tax due to the IRS and the State is $20,000. Now Do The Math! If you borrowed $100,000 and paid $15,000 to satisfy the entire debt and $20,000 in taxes for the forgiven portion of the debt you legally made $65,000 ($100,000 less the $15,000 settlement and the $20,000 tax).
- Focus your energy on settling second mortgages and/or HELOCs. Most lenders that provided second mortgages and/or HELOCs are not counting on receiving money from a foreclosure sale. If the lender wants to recover money then there are two options. The lender will sue or the lender will settle. In fact, anyone considering a strategic default must make settlement of a second mortgage and/or HELOC a top priority. Even if the primary first mortgage loan is in default or foreclosure, you must put resources towards settling second mortgages and/or HELOCs. The total amounts due by a borrower on these types of loans can be significantly high. I have seen outstanding balances range from $80,000 to $500,000. If second mortgages and/or HELOC’s are not settled or resolved it will cost you in the years to come. This principle applies to business loans and credit cards.
- Understand the risks and benefits of a short sale, deed-in-lieu, or foreclosure sale. A properly negotiated short sale or deed-in-lieu never exposes a borrower to a deficiency judgment. A foreclosure sale can expose a borrower to a deficiency judgment. A short sale is when a lender agrees to allow a home owner to sell a property for an amount less than what is owed on the mortgage loan. The key to a successful short sale is to enter into a written agreement wherein the lender agrees to forgive the deficiency. Keep in mind that some lenders may require a cash contribution from the property owner in order to forgive a deficiency that arises from a short sale. Chase, Wells Fargo and Bank of America are offering "qualified" homeowner's cash incentives, up to $35,000, to complete a short sale. If you are interested in a short sale, you should ask your lender if you qualify for a cash incentive. A deed-in-lieu is when you enter into a written agreement to give the property back to the bank. The key to a successful deed-in-lieu is to negotiate a full settlement of the total outstanding mortgage debt, including fees and penalties, in exchange for the deed to the property. A full settlement of the total outstanding mortgage debt eliminates any deficiency and any tax liabilities. A partial settlement still leaves open the possibility of a deficiency judgment or forgiveness of the remaining balance.
- Once a lender or creditor obtains a deficiency judgment it can remain effective for as long as 20 years in some states. This raises a critical issue for strategic defaulters. It is common knowledge that most strategic defaulters stop making loan payments despite having the money to make the payments. Strategic defaulters generally have savings, assets, and income. Therefore third party debt collectors, who purchased debt for pennies on the dollar, can afford to wait 3 to 5 years years to collect and still make a sizable profit. This means resolve and/or settle the debt as soon as possible.
- Bankruptcy is not a bad word. It is a financial tool. The purpose of filing for bankruptcy is to assist the borrower in controlling the payments of outstanding debt and to give a borrower a "fresh financial start". It essentially puts creditors on freeze until a borrower can re-organize his financial assets. As time goes on bankruptcy will lose its negative social stigma as more people realize it can be an effective solution to their debt issues. The best way to approach bankruptcy is to understand what it can and cannot achieve. The United States Federal Courts has created an informational website that provides "Bankruptcy Basics". You can also seek the advice of a qualified bankruptcy attorney.
- Start to practice the principles of asset protection, right now. Simply put, asset protection is the implementation of legal structures, techniques, and strategies that protect and preserve what you earn, what you create, and what you acquire. Asset protection will help you create defensive and offensive strategies against any individual or entity seeking to get their “hands” on your assets. For a basic introduction about asset protection please read our link Protect Your Assets by Kenneth F. McCallion, Esq.
- Follow the principle Never Keep All of Your Money In The Same Bank. This means that if you owe Citibank money then you should not maintain any savings or cash accounts, including business accounts, with Citibank. In our current technological age, all it takes is a social security number and a push of a button to obtain financial information connected to the social security number. Don’t be fooled. Lenders and creditors will never admit to having access to this info yet in reality they do.
- Deficiency debt grow likes a vine. It is easy to ignore the growth cycle of a vine. Initially we see the vine growing up the tree, fence, or house. Since it is slow growing we really don't pay attention. Then one day the vine has covered a large section of the fence or the entire side of a house. A vine will continue to grow unless it is taken out by its root. The way to stop the growth of debt is to resolve it at its root cause. In other words, resolve debt by permanently eliminating the debt, settling the debt, paying all of the debt, or modify the debt.
We are all concerned about our future during this economic downturn. We are seeking strategies that will put us in a better financial position. The fact is a strategic default can be an effective financial strategy to preserve and/or increase savings, cash, and wealth. It is important to eliminate the risk of deficiency debt in order to achieve maximum results from a strategic default.
In the end, whatever strategy you choose must be based upon your unique circumstances and must help you achieve your desired financial outcome. I urge you to act now.
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