Last updated April 15, 2016.
When you take out a mortgage loan, you borrow a specific amount and agree to pay that amount back. Unfortunately for homeowners in times of recession, the amount of your mortgage isn’t tied to the value of your home. That means the value of your home can drop until it’s is less than what you owe the bank. That’s called an “underwater mortgage.” An underwater mortgage is a difficult burden to bear – you have to keep pouring money into a home even though it’s not worth the cost. Moreover, your interest rates are probably rising, making your monthly mortgage payments more and more difficult. There’s no clean and easy way to walk away from your mortgage, but you do have options.
When Should I Walk Away From My Mortgage?
The answer is going to be different for everyone, but at a certain point your mortgage will stop making sense. If you’re struggling to make payments and you owe more than your home is worth, you’re essentially throwing money away. You’ll need to sit down with all of your finances and decide how much you can afford to continue to pay and how much your home is actually worth. If your payments are manageable and your home is only slightly underwater or if the housing market looks to be on a solid upswing in your area, you may choose to wait it out and hope that the value of your home increases past what you owe. If the payments are a hardship and you don’t expect the house to go up in value, it may be time to walk away.
How To Walk Away From A Mortgage
When you’re ready to walk away from your mortgage, you have several options.
First, you can talk to your bank about a short sale. In a short sale, you sell your home for whatever you can get on the market. If your bank specifically agrees to it, the bank will take the proceeds of the sale and forgive the rest of your debt. If not, you’ll still be responsible for the deficiency, or the difference between what you got for your home and what you owed on the mortgage. A short sale is a difficult move – the bank has to approve it and approval is difficult to get, especially in an economic downturn, where lots of homeowners are likely to be seeking that sort of approval. Approval is also a slow process, during which you’ll still have to make your mortgage payments. In some states, the amount of debt forgiven in a short sale counts as income and you’ll have to pay tax on it. In California, the forgiven debt is generally not counted as income, so you don’t have to worry about incurring an extra tax liability.
If you can’t get approval for a short sale, you may choose to simply stop making payments and allow the bank to foreclose on your home. That process can take anywhere from a couple of months to years or more, depending on your bank’s backlog of foreclosures. The upside is that you can save up some cash while your bank processes the foreclosure. You’ll effectively live in your home without paying for it until the bank forecloses. The downside is that you’ll still owe the difference between the price you get at a foreclosure sale and your remaining mortgage loan balance. If your lender forgives the deficiency, you may have to pay tax on that amount as income. Both foreclosures and short sales show up on your credit report and damage your credit score.
Underwater Mortgages And Bankruptcy
Bankruptcy is probably not your top choice for dealing with financial troubles. However, bankruptcy does offer a way out of your underwater mortgage. You can file for bankruptcy under either Chapter 7 or Chapter 13 as a consumer. With both types of bankruptcy, you get the protection of the automatic stay. The automatic stay stops all collection actions and foreclosure proceedings while your bankruptcy is in process. That gives you some breathing room to decide what to do with your home. Under Chapter 7, you’ll liquidate your non-exempt assets and pay the proceeds to your unsecured creditors. In Chapter 13, you’ll work out a three- or five-year payment plan to pay down your unsecured debts. In either type of bankruptcy, your remaining unsecured debt is discharged at the end of the process.
So what does that mean if you want to walk away from a mortgage? A mortgage, of course, is secured debt. Your home is the collateral. Bankruptcy deals with secured debts, too – it wipes out your personal liability for them. In other words, you’ll still owe the debt, but the bank can’t come after you for payment. If you don’t pay, the bank’s only option is to reclaim the collateral. In this case, that’s your home. So they’ll still go through the foreclosure process and take the home. However, the bank can’t sue you for the deficiency if they get less for it than you owe. That means you can either continue to make payments without the threat of personal liability or you can walk away from the mortgage and the bank can’t come after you for it.
What if you decide you want to keep your home? Bankruptcy has options for that, too. Under Chapter 13, you can make up your back mortgage payments through your payment plan and get back on track. Under Chapter 7, you can choose to “reaffirm” your loan if you can show the court that you’ll be able to make the payments.
Bankruptcy will show on your credit report but your credit score is already suffering if you’re delinquent on your mortgage. If your mortgage is underwater, reach out to one of our experienced bankruptcy attorneys to discuss your goals and your options.
M. Erik Clark is the Managing Partner of Borowitz & Clark, LLP, a leading consumer bankruptcy law firm with offices located throughout Southern California. Mr. Clark is Board Certified in Consumer Bankruptcy by the American Board of Certification and a member of the State Bar in California, New York, and Connecticut. View his full profile here.